Chapter Twenty-One
With a prescience that evaded other, sharper intellects, President Warren Harding broached a truth about capitalism in 1922 that would dominate its development in the last half of the twentieth century. In a letter to the chairwoman of the Better Homes Campaign, he suggested that it was time to think of the place where Americans lived in a new light. Homes provided more than shelter. They were “absolutely elemental in the development of the best citizenship,” the president asserted, and for “twenty millions of house-keepers,” they served “as their industrial center as well as their place of abode.”
Enthusiastically endorsed by his secretary of commerce, Herbert Hoover, the government’s sudden concentration on the economic importance of the home was intended to attract the votes of newly enfranchized women. But its long-term importance emerged as the makers of automobiles, refrigerators, washing machines, and vacuum cleaners responded to the buying power of the home market. By 1929, the production of refrigerators had grown from 315,000 units in 1919 to 1.7 million; the number of radios in use multiplied fourteen times to seven million, and the automobile industry sold more than twenty-three million vehicles, employed 427,500 people, and sustained a distribution and service organization with sales of almost five billion dollars. Although muted by the 1930s depression, the economy that grew up around the home would galvanize the production of steel plants and plastic factories, transport and energy suppliers, and the provision of financial, marketing, and advertising services.
By the end of the century, the consumer economy, a sector in its infancy when Harding drew attention to it, was responsible for about 70 percent of the gross domestic product of the United States. In the opinion of a stream of economic commentators, from Thorstein Veblen at the beginning of the century to J. K. Galbraith near its end, it also provided one answer to industrial capitalism’s crisis of overproduction.
“When a family buys a home, the ripple effect is enormous,” President Clinton explained in 1995. “It means new homeowner consumers. They need more durable goods, like washers and dryers, refrigerators and water heaters. And if more families could buy new homes or older homes, more hammers will be pounding, more saws will be buzzing. Homebuilders and home fixers will be put to work. When we boost the number of homeowners in our country, we strengthen our economy, create jobs, build up the middle class, and build better citizens.”
The new phase of land ownership was clothed in the same term, “property” and in declaring it to be elemental to citizenship both Harding and Clinton assumed that it conferred on the owner the old Jeffersonian attribute of republican independence. But the twentieth-century home differed in one radically different way from the nineteenth-century property whose relatively modest investment morphed readily into rural capital. Purchased with a mortgage, and equipped with labor-saving machinery paid for through bank loans and credit agencies, the new version came with a scale of debt that required most of a forty-year working life to pay off. Until it was, ownership was shared with the mortgage lender and credit issuer.
This dependency locked the new homeowners of the 1920s into the structure of modern mercantile capitalism. The mortgage corporations, banks, and other financial institutions from which they borrowed made their profits by borrowing in turn more cheaply than they lent. In the wake of the carnage and expense of the First World War that atomized London’s financial dominance, Wall Street had become the international banking center of the world and the institutions’ largest source of funds. The amount banks could raise and the price they paid for Wall Street’s involvement were determined partly by the stock market—through the value of banking shares—but to a growing extent by the market’s willingness to buy their bonds. To a degree unknown in the nineteenth century, property values in the new consumer societies were influenced by interest rates on Wall Street.
Not fully appreciated in the 1920s, however, was the Ponzi effect of allowing the same financial market to fund both industry’s capacity to produce and homeowners’ appetite to consume. From 1918, when fewer than one hundred thousand new homes were built, the dream of ownership drove housing construction to a spike of 550,000 units begun in 1927, and mortgage lending ballooned from about seven billion dollars to twenty-seven billion. On the back of this boom and the accompanying demand for automobiles and other machines to save time and labor, the American economy grew by 4.2 percent a year through the Roaring Twenties to more than one hundred billion dollars. In other words, the larger and more dynamic part of it was based on the construction, equipment, and servicing of the industrial home, and that in turn depended on the interest rates charged on Wall Street’s bond market.
The first hint of the economic difference this made compared to the earlier economy primarily based on rural capitalism came when the stock market collapsed in the fall of 1929. Remembering the depression of 1873, when falling prices and wages cut the demand for goods, precipitating the downward spiral into depression, President Herbert Hoover’s overriding priority was to prevent a recurrence.
The entire strategy of his administration, enthusiastically endorsed by business, industry, and labor leaders during a series of conferences in December 1929, was designed to maintain people’s buying power and keep demand healthy. Until late in 1931, employers were pressed to maintain wages at pre-crash levels and corporations to keep dividend payments high, and the profits of both were protected against cheaper foreign goods by tariffs averaging 50 percent, introduced under the 1930 Smoot-Hawley Act.
Hoover’s strategy was doomed to fail because it ignored the post-1873 economic climate. Wages and dividends played a small part in the consumer economy compared to credit. Unless the financial institutions could generate enough credit to stimulate overconsumption by the industrial home, overproduction would inevitably cut industrial profits. But when the banks lost confidence following the stock market crash, the engine went into reverse, sucking so much credit out of the system that the human owner of the industrial home, hit by a perfect storm of unemployment, high interest rates, and foreclosure, could not buy anything at all, leaving industry with a pile of goods it could not sell. The solution, according to Ben Bernanke, the twenty-first century’s acknowledged expert on the depression, was for government to generate its own credit—quantitative easing as it became known following the 2008 crash—that could be channelled through the banks and finance houses restoring their readiness to lend once more, especially to the industrial home owner.
In the 1930s, governments groped blindly for a way out of the nightmare until in 1931 Britain decided to let the value of its currency fall by unpegging it from the gold standard. As Milton Friedman, the father of monetarist economics, would later explain, leaving the gold standard removed the need for high interest rates to prop up the currency, making credit easier and increasing the money supply, thus delivering a stimulus to kick-start demand in the consumer economy. The decision was forced on the British government, as in every other country that adopted the measure, by democratic pressure coming from the unemployed. “The deterioration of the conditions of millions of workers,” declared Ernest Bevin, a senior British parliamentarian, “was too high a price to pay for the maintenance of a single industry [London’s financial institutions].”
In the United States, the financial crash destroyed credit on a scale that dwarfed Hoover’s attempts to keep cash flowing, and the deflationary effect was exacerbated by his decision to raise income tax. By the end of 1932, two fifths of the nation’s 1929 wealth had evaporated, about ten thousand banks, more than a third of the total, had failed, and one in four workers was unemployed. Although the U.S. finally came off the gold standard in 1933, the extent of the devastation was not fully repaired until the gigantic managed economy of the Second World War, allied to the massive public works of the New Deal, had eliminated unemployment and restored demand.
The entrails of the 1930s depression were picked over endlessly by economists of all kinds, but few did so more obsessively than those belonging to what became known as the Austrian School. Its general stance was articulated early by the most eclectic of its leaders, the abrasively inventive Joseph Schumpeter.
Among the host of fertile ideas that Schumpeter planted in the economic garden, two stood out: the belief that a capitalist economy was subject to uncontrollable cycles of expansion and contraction, and that these upheavals allowed innovative entrepreneurs to overthrow outmoded methods and technologies in a process Schumpeter termed “creative destruction.” His 1930s Harvard economics class should not have been surprised, therefore, when the professor declared in his heavily accented English, “Chentlemen! A depression iss for capitalism like a good cold douche.”
Not only was the 1929 financial crash a natural corrective to the inflationary decade before it, but the business cycle and entrepreneurial activity would in time naturally take advantage of the availability of cheaper goods and labor to bring about economic recovery. Thus, Schumpeter’s advice during the Depression, backed by two fellow Austrian economists, the upper-class Ludwig von Mises and his protegé, Friederich Hayek, sounded uncannily like an eighteenth-century physiocrat counseling the heir to the French throne, “Do nothing.”
In the late twentieth century, the politics of all private property societies would be profoundly influenced by Austrian economics, not least because at its heart lay a ferocious defense of property. But the theory that von Mises presented about the origin of property gave it a significantly different character. In Socialism, a coruscating attack on the political force that had supplanted imperialism in his native Austria after the First World War, von Mises imagined property emerging from a world as brutal and chaotic as anything Thomas Hobbes described, in which the strongest battled to win and keep as much as they could defend against their rivals. “All ownership,” the Austrian declared bluntly, “derives from occupation and violence.”
Over time, social order had spontaneously spread without any need for a Leviathan government, driven simply by people’s recognition of the economic benefits of stability. “Out of violence emerges law,” von Mises stated, adding that any further explanation about the origin of the law was meaningless. But the law had a power as irresistible as Leviathan’s because it preserved peace, meaning that any who opposed it must want war. For that reason, the law’s first priority was to defend property—“All violence is aimed at the property of others”—regardless of the circumstances by which it had been acquired. “Possession is protected even though it has, as the jurists say, no title. Not only honest but dishonest possessors, even robbers and thieves, may claim protection for their possession.” In short, might became right, because it delivered the economic goods.
Von Mises swiped aside both John Locke’s argument that there was moral authority based on a sense of natural justice involved in the creation of property, and the Enlightenment’s theory that government emerged as a rational contract between individuals to preserve their property. Natural rights and natural justice did not exist—“all rights derive from violence,” von Mises repeated, “all ownership from appropriation or robbery.” Human nature had evolved from an animal state, he insisted, and this Darwinian process made “the idea of a human nature which differs fundamentally from the nature of all other living creatures seem strange indeed; we no longer think of man as a being who has harbored an idea of justice from the beginning.”
In his lifetime, the resolutely snobbish von Mises—he clung to the “von” for fifty years after Austria had abolished the rank—invested his philosophy with a Central European air of sophistication and realism. But reading Socialism without the persuasive charm of his Viennese accent and dapper presence, it is impossible not to be aware how restricted he was by his background.
The empire in which von Mises lived until he was almost forty years old had only recently emerged from being a serf society—nominally abolished in Austria in 1848 and in Hungary in 1861 while leaving the power of their aristocratic lords intact—and his understanding of democracy was based on the primitive, ramshackle structure that still answered to Emperor Franz-Josef II. Politically, the empire was virtually unworkable, consisting as it did of two autonomous kingdoms, Austria and Hungary, joined from 1861 in a union known as the Dual Monarchy, a semiautonomous state in Czechoslovakia with its own assembly and a dizzying number of provinces, each with its own legislative council, language, and culture.
Neither federated nor bound by a common set of laws, it was held together by three institutions: the emperor to whom the imperial army and executive governments of each monarchy were answerable; the aristocratic instincts shared by its nobility and reinforced by an overtly political and conservative Catholic hierarchy; and the dictatorial Austro-Hungarian National Bank, staffed by dazzlingly brilliant economists in Vienna and Budapest, whose independence from political constraints enabled them to control a single currency across a wildly heterogeneous empire, and in 1892 to impose a belt-tightening shift to the gold standard with barely a squeak of opposition.
The state of the Austro-Hungarian Empire confirmed von Mises’s unwavering belief that economics came before democracy. But the idea originated with his mentor, Carl Menger, the founder of the Austrian School, who argued that in its “natural” state, an ordered economy would be self-generating and, over time, self-adjusting, with no need for government interference—the business cycle, elaborated later by his students, was one of Menger’s original concepts. Even the crisis of overproduction would solve itself by the inevitable formation of cartels and price-fixing agreements within the different business sectors, independently of any official intervention.
One of the most powerful examples Menger presented of this spontaneous growth of order was the way that money, meaning paper and credit as well as cash, generated itself once traders agreed on a medium, such as bills of exchange and promissory notes, to take the place of barter. “The origin of money (as distinct from coin, which is only one variety of money) is, as we have seen, entirely natural,” he concluded. “Money is not an invention of the state. It is not the product of a legislative act.”
The golden era of Austrian finance ended in the shattering defeat of the First World War and the election of a social-democratic government in 1919 that was for the first time in the country’s history responsive to the electorate. Among its most far-reaching actions was a program to redistribute aristocratic property. Thus the one article of faith that von Mises took with him into exile was a belief in economic freedom, a Menger-like absence of interference by government, epitomized by the unfettered possession of property. It was, therefore, incumbent on owners to be ready to defend rights that they alone had created by force, and any action by government must represent the first step toward a Socialist usurpation of their independence.
The most articulate of von Mises’s students, Friederich von Hayek—in later life he dropped the “von”—wholeheartedly adopted his mentor’s suspicion of government. His bestselling book, The Road to Serfdom, published in 1944, was a savage hymn to the belief that economic freedom could be equated to individual liberty.
There was no difference between Fascism and Communism, Hayek warned, or for that matter between Nazi Germany and the democratic governments who were attempting to defeat it by managing their economies to maximize wartime production. “Most of the people whose views influence development,” he declared, “are in some measure socialists. Many who sincerely hate all of Nazism’s manifestations are working for ideals whose realization would lead straight to the abhorred tyranny.” Once embarked on the path of planning, Hayek predicted, any state would inevitably end up as a dictatorship. “Planning leads to dictatorship,” he wrote, “because dictatorship is the most effective instrument of coercion and, as such, essential if central planning on a large scale is to be possible.”
Hayek’s followers attempted to soften the doomsday tone by explaining it as the consequence of his despair at the government-directed nature of wartime economies. But his diatribe had deeper roots in political ignorance.
Hayek had arrived in Britain in 1931 at the invitation of the London School of Economics, where his rigorous insistence on the unfettered working of market forces was welcomed as a corrective to Keynesian economics. But even after a decade of living in a parliamentary system, when he came to write his polemic, Hayek still did not appreciate that in a democracy, sovereignty lies in the electorate rather than in the government. What was government strategy, he took to be state policy, as would have been the case in Vienna where the imperial government was responsible to the aged emperor rather than to the voters.
By 1960, Hayek was well aware of the difference, and in that year he set out to describe from first principles how a capitalist democracy should work. In The Constitution of Liberty, he wrote one of the late twentieth century’s most influential books on political economy. In 1979 Margaret Thatcher banged a copy on the table at a meeting with senior figures in Britain’s Conservative Party soon after becoming leader and told them, “This is what we believe in.” Its precepts formed the core of her policies, and jumped across the Atlantic to seed the low tax, government-light politics known generally as Reaganomics. Well into the twenty-first century its libertarian principles still informed much of the political debate on both sides of the Atlantic.
Hayek started with a bold statement that dismissed the possibility that a person might be born with inalienable natural rights. Even freedom was alienable and could be sold, he insisted—“a person may . . . contract himself into slavery.” It followed, therefore, that “Freedom is not a state of nature, but an artefact of civilization.” Removing the claim to inalienable rights to life, liberty, and the pursuit of happiness might still have left intact the fundamental tenet of common law that a craftsman had a natural right to property in his own work, but that too was excised. Having cleared out the central beliefs of a private property society, Hayek inserted in their place a model like that imagined by his teacher, von Mises, in which the creation of property, the conditions of a market economy, and the rule of law all arose spontaneously, as people recognized these ingredients to be essential to the efficient working of their communities.
The elimination of natural rights from Hayek’s society, otherwise apparently identical to that of a private property society, also did away with the social fairness or natural justice that in John Locke’s and Adam Smith’s theories had held society together and allowed the operation of the hidden hand to take place—Hayek in fact subtitled a later book The Mirage of Social Justice. Its place was occupied by the working of the marketplace that engaged everyone’s efforts and rewarded everyone accordingly.
Hayek did not pretend that the rewards would be equitable, but argued they were just. In a flight of genuinely innovative thinking, he explained that the very imperfections of a free marketplace made it a more efficient means of rewarding effort than a centrally planned system. Because it involved many players, each forced to adjust to local conditions of supply and demand but equipped with only fragmentary knowledge of the wider world, the market would react more quickly and appropriately to the unpredictable complexities of life than would a centrally directed structure aiming at perfect knowledge and a rational response.
The substitution of the marketplace for any deliberate or government solution to social problems required the mechanism to work without interference. To create the necessary conditions, Hayek picked out the central importance of freedom, which he defined in its negative sense as “the absence of restraint and constraint”—any positive definition, he warned, would permit government to promote its own values. In practice, this meant that governments had to intervene as little as possible, because any intervention distorted the market, reduced freedom, and introduced inequality. Conspicuously, these threats were only posed by government, not by trusts, cartels, or monopolies, however large their budgets or extensive their operations. Nevertheless, he did allow that a government might provide for the poor “some minimum of food, shelter and clothing, sufficient to preserve health,” although treating it as a charitable donation to keep them quiet rather than as a reciprocal to property rights.
This description of how society should work left it with no other collective purpose than to grow richer, and Libertarians in particular welcomed the lack of social values in its individualized, marketplace ethos. But Hayek himself rejected any association with libertarian thinking. His own values were, he said, those of Britain’s nineteenth-century Whigs. It was a revealing admission. Throughout The Constitution of Liberty ran an implicit and sometimes explicit argument for the leadership of an elite, such as Hayek believed to have existed up to the 1880s.
By rewarding winners without limit, he believed, the marketplace would give rise to a “leadership of individuals or groups who can back their beliefs financially.” This financial aristocracy was not only needed for “the preservation of competitive enterprise,” but, according to Hayek, “is particularly essential in the field of cultural amenities, in the fine arts, in education and research, in the preservation of natural beauty and historic treasures, and above all in the propagation of new ideas in politics, morals and religion.” The wealthy leaders of society might emerge by their own energies, but Hayek believed there were clear advantages to “selection through inheritance from parents,” since those born with a silver spoon in their mouths would have been trained for the task.
To ensure that society could benefit from the wealth and ideas that came “filtering downward from the top of a pyramid,” Hayek was adamant that taxation should not fall most heavily on the richest. Unlike Adam Smith who believed “It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion,” Hayek was certain that progressive taxation represented discrimination against the elite minority. Unlike the dull mass of people who simply did the jobs given to them without thought, the minority of “independents” as he dubbed them, were the enterprising creators of wealth whose freedom needed to be protected from the constraints of taxation, regulation, and intervention by a government representing the envious interests of the majority.
With its aristocratic agenda excised, however, Hayek’s thesis looked like a return to eighteenth-century laissez-faire economics. The market was expected to take care of itself, and the crisis of overproduction would be sidelined by a combination of supply-side economics to stimulate consumption, an aggressive takeover culture to reduce competition, and the business cycle’s creative destruction of weaklings. In effect, an Austrian cuckoo had laid its egg in the private property nest.
The difference was not immediately apparent during the postwar years. Social democratic governments in Europe and Scandinavia developed more or less planned economies that nineteenth-century Prussian economists would have recognized, nationalizing strategic industries such as railroads and steel production, and providing universal health care systems, old-age pensions, and social care. In 1948, the British welfare state came into being with the creation of the National Health Service, free education to the age of fourteen, and a program of nationalization devoted to maintaining full employment.
Even in the United States, New Deal intervention and wartime planning spilled over into the postwar years. In the 1950s, the Eisenhower administration inaugurated the largest public works project in peacetime since the Public Lands Survey with the creation of the forty-six-thousand-miles Interstate Highway system, and was followed in the same decade by President Kennedy’s launch of NASA and the moon landing project at a cost of up to twenty-five billion dollars, or 4 percent of the national budget. Both were dwarfed by federal and state expenditure on Medicaid for the elderly and Medicare for low-income families following President Lyndon B. Johnson’s Great Society in 1965.
To pay for this, U.S. personal taxes on income rose up to 75 percent and and on dividends up to 95 percent, in theory although in practice the top rate was about 60 percent. The heavily taxed and regulated economy grew at 3.7 percent a year from 1950 to 1973, and Wall Street returned an annual rate of 9.58 percent to investors during the same period. In Britain similar figures—GDP growth of 3.1 percent annually from 1964 to 1973, and stock market returns of about 8 percent from 1950 to 1970—prompted the respected Financial Times economist Samuel Brittan to describe this period as “a Golden Age, which achieved far higher growth than experienced during any sustained period before or since.”
Between 1950 and 1980 the population of the United States surged by 50 percent to 226,000,000. In the last ten years before the contraceptive pill was legalized in 1965, almost forty million babies were born, the most fertile decade in American history. The distinctive culture that these new Americans grew into was shaped by the force that Warren Harding had first identified in the 1920s, the industrial home.
Regulation of the hybrid consumer economy, notably through the 1933 Glass-Steagall Act that separated retail banking and mortgage lending from investment banking, kept house prices roughly in line with incomes from the 1940s to 1970s. But a notable change took place during the period. At the end of the Second World War, almost half of all Americans rented their homes; three decades later almost two thirds of them owned the place they lived in, either completely or with finance borrowed from one of more than three thousand savings and loans associations—cooperative financial institutions, equivalent to British building societies, that were dedicated to providing mortgages for their members. And most of these hybrid properties were located in the suburbs—by the 1980s, more American lived there than in cities or the countryside.
In the United States, the prototype was Levittown, Pennsylvania, created in 1951 by William Levitt, whose homogeneous, factory-assembled houses—he described his company as “the General Motors of the housing industry”—were lined up along curved streets and around a church, a school, and a leisure center in self-contained communities. The nature of suburbia’s inhabitants was pored over by sociologists like Herbert Gans, sexologists led by Alfred Kinsey, and novelists among whom none surpassed John Updike, whose driven, promiscuous, selfish, idealistic creation, Harry Angstrom, known as Rabbit, embodied suburbia’s conflicted yearning for social esteem and personal freedom, for admission to the country club and sex with the minister’s wife.
Debarred from influence until the 1970s, the political implications of Austrian economics were best explored not in fact but fiction. In Atlas Shrugged, published in 1957, the Russian-born, Hollywood scriptwriter Ayn Rand imagined how the potential giants of industry might escape the crippling effects of government regulation and social convention whose purpose was to spend their profits on “parasites” and “looters.” According to her protagonist, John Galt, every attempt by government to regulate entrepreneurs or to tax them beyond what they wished to pay represented an assault on their fundamental right “to think, to work, and to keep the results—which means the right of property.”
Recognizing that Austrian economic theory was being given popular form in her novel, Ludwig von Mises, by then in New York, sent Rand a fan letter soon after Atlas Shrugged was published, praising her “cogent analysis of the evils that plague our society.” He added that he especially admired the unashamed elitism advocated by her book: “You have the courage to tell the masses what no politician told them: [that] you are inferior and all the improvements in your conditions which you simply take for granted you owe to the efforts of men who are better than you.”
That the upper-class von Mises should hold “the masses” in contempt was understandable; all the Austrians, even the maverick Schumpeter, shared a nostalgia for the old imperial form of politics. But it was less easy to see why such sneering views should have been adopted most enthusiastically in the republic that most prided itself on being democratic. The best insight, however, would come from the career of Ayn Rand’s leading disciple, Alan Greenspan.
In the early 1950s Greenspan had come upon Rand’s Nietzschean philosophy which, because it equated self-realization with the discovery of an objective reality, she termed “Objectivism.” As a brilliant, geeky young economist, devoted to mathematics but with few other interests—“intellectually limited” by his own admission—Greenspan adopted its tenets “with the fervor,” he wrote in his autobiography, “of a young acolyte drawn to a whole new set of ideas.” Out of his exposure to what he called “a remarkable course in logic and epistemology” came his conviction that postwar economic policies were not only inefficient, but, unless resisted, must lead to dictatorship. Government should control the money supply, he believed, but otherwise businesses could be left to pursue their own interests in the certainty that “unfettered market competition” would resolve its own problems, and that economic liberty was synonymous with individual liberty.
Greenspan’s capitalism drew on von Mises’s insistence that property existed as an absolute possession, founded on violence, and preserved on grounds of materialist self-interest. As a result, he and Rand took the Austrian view that government and property must forever be at one another’s throats. It was erroneous to suppose, as James Madison had, that a democratic government should strike a balance between the interests of property and those of the propertyless. Any interference represented an attack on property.
By the early 1970s, the costs of the Vietnam War added to government expenditure on highways, the space race, and President Johnson’s “Great Society” were creating an unsustainably inflationary effect. At the same time, the U.S. began to import oil for the first time, and when the OPEC oil cartel abruptly cut the supply in 1973, quadrupling its price, the American economy, followed by the rest of the industrial world, stalled in a stagflationary cycle of falling production and rising prices.
In its attempt to break the cycle, Britain became the first private property economy to hatch the Austrian egg. After her election in 1979, Prime Minister Margaret Thatcher began a crusade on behalf of Hayek’s economics. Her privatization of Britain’s airlines, telecommunications, energy suppliers, and even public housing were all inspired by his “crisp, clear analytical arguments against socialism.” In 1986, her government endorsed the deregulation of the City of London’s financial markets in a single measure, known as the Big Bang. Not only were the barriers between investment and commercial banking abolished, it became apparent that virtually any kind of institution of any nationality that borrowed and lent money could trade with the lightest supervision in London’s financial markets. In the fallout, Wall Street’s greater muscle allowed American investment banks such as Goldman Sachs and Lehman Brothers to prosper in London, providing an extra inducement to push for the same sort of freedom in the United States.
In 1986, President Ronald Reagan signaled his own conversion to the Austrian outlook in his much-quoted quip, “The nine most terrifying words in the English language are ‘I’m from the government, and I’m here to help.’ ” But under his administration, Hayek’s philosophy of deregulation was bundled up with the conceptually different monetarist theories of Milton Friedman and the Chicago School of Economics.
Monetarism, which aimed to control inflation by regulating the supply of money, both cash and credit, gave rise to the austere banking policies pursued by Paul Volcker, Greenspan’s predecessor in charge of the Federal Reserve in the early 1980s. Volcker pushed interest rates to Himalayan heights in order to bring inflation under control. But this was accompanied by deregulation of a range of industries from airlines and telephones to natural gas and savings and loans associations until the finance industry, still regulated by the Glass-Steagall Act separating investment from commercial banking, was left as the last important holdout. The fate of the deregulated S&L associations, once famous as the safe “thrifts,” now trying to operate as credit-generating banks, might have given pause for thought. Caught in a competitive spiral of risky loans, poor management, and inadequate funds, almost a third of them became bankrupt, and rescuing the industry cost almost nine billion dollars of taxpayers’ money.
Nevertheless, encouraged by Greenspan, beginning his five-term tenure of the chairmanship of the Federal Reserve, American banks chipped away at the regulations until in 1997 Glass-Steagall was repealed. With the lifting of restrictions on derivatives dealing in 2000, the financial market had become unified. And the industrial home, driver of the consumer economy, became once more what it had been in the Roaring Twenties, a functional adjunct to Wall Street.
In evidence to Congress in 2008, Alan Greenspan would later admit there was “a flaw” in his faith that “unfettered market competition” would sort out its own distortions. The flaw was the one exposed by the bankruptcy of Lehman Brothers with six hundred billion dollars of assets—that a player might be so big its collapse would destroy the market itself. But his belief in Austrian economics blinded him to a more fundamental weakness, a contradiction within the theory of financial nonregulation that guaranteed its failure.
Integral to Carl Menger’s innovative theory about the spontaneous creation of money was that it came about as an “entirely natural” agreement between self-interested traders and required no state intervention. From this observation, Greenspan, following Hayek, von Mises, and a rapidly growing band of like-minded bankers, drew the conclusion that government intervention had no place in the operation of financial markets. While the events following deregulation proved the truth of Menger’s theory, they also exposed the mistake in his disciples’ reasoning.
The most notorious example was to be the way that traders in investment banks took the mortgages held by commercial lenders and bundled them up for sale to other traders as interest-bearing bonds—“securitized” was the word for the process and “consolidated debt obligations” was the label pinned to the product. The minutiae of how consolidated debt obligations and other derivatives were created mattered less than the end result: by creating a market for them, a new form of money had been spontaneously generated. What had been a debt indirectly secured against the value of a property was now transformed into an asset that appeared as such in the bank’s accounts, and against which it could borrow. Such was the traders’ confidence in these invented assets, the level of borrowing quickly rose until it was leveraged at three or four times their supposed value.
Once a mortgage became not just an accountancy asset with an equivalent item on the debit column but a trading asset that increased the capital value of the lender, it became logical for the sales forces working for any kind of lending institution to create as much debt as possible. Even the notorious “Ninja” loans to borrowers with “no income, no job, and no assets” became valuable. By March 2007, the value of subprime mortgages was estimated to be $1.3 trillion. The same process converted credit default swaps, the insurance issued against such transactions going wrong, into capital assets, and the insurance on foreign exchange trades underwent the same process. So long as investment traders agreed, anything could become money.
This was the fundamental flaw in Austrian economic theory that Greenspan failed to see. No economy, and ultimately no government, could survive the convulsions in money supply created by the spontaneous generation of money on this scale. The consequences of Menger’s theory were the opposite of what his twentieth-century followers had claimed—they made government regulation of financial markets absolutely essential.
Having stepped down in 2006, Greenspan was no longer personally involved when it became clear that the corollary of Menger’s theory was equally true—that money could be degenerated just as spontaneously. As news spread of the rising default rates on risky mortgages, trade in derivative bundles dwindled, and then quite suddenly in the summer of 2008 their standing as capital assets evaporated.
At a stroke, the health of financial institutions that held them became poisoned. The roll call included the investment bank Bear Stearns, with eleven billion dollars in equity but almost four hundred billion in potentially worthless assets; the American International Group, the largest insurers in the world, notionally worth more than $110 billion but whose London office alone issued credit swap defaults valued at more than $440 billion; and the blue-blooded investment bank Lehman Brothers, broker to more than a hundred hedge funds, with equity of $639 billion but potential debts of $1.3 trillion.
When Lehman Brothers was allowed to go bankrupt in September 2008 as Austrian economics required, the Dow Jones index dropped five hundred points, stock markets around the world fell by close to 5 percent, and more significantly, banks stopped lending to each other. The realization that money could dissolve so quickly left every financial institution haunted by the same nightmare: any bank, however vibrant it appeared to be from its visible asset sheet, might turn out to be bankrupt when the real value of its untradable assets was revealed. The marketplace was filled with zombie banks, and it was impossible to tell the living from the living dead. Fear halted lending and brought the entire mercantile capitalist system close to gridlock.
In every country, the rescue plan involved government intervention on a massive scale. In the United States alone, government guaranteed more than one trillion dollars in direct rescue funds, followed by trillions more in federally invented money, the so-called quantitative easing, designed to take the place of traders’ invented money and persuade the banks to start lending again.
The Austrian experiment had failed.