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Tooth Fairy Economics…a brilliant article

Tom Woods, one of the brightest free market economists out there today, recently wrote a great article on the Campaign for Liberty website called Tooth Fairy Economics (found here ). For those with little time on their hands and want a quick overview of what he discussed, let me highlight some of my favorite parts.

Woods starts by talking about the “stimulus” plan and how so called conservatives in Congress have railed against it using the “pork” argument. While I respect the republicans merit in coming together to oppose it and their ingenuity in creating derogatory names for it such as the “porkulus” bill, they really need to stop using the some old talking points. Yes we know the democrats love to spend, but so did the republicans the past 8 years! While the stimulus package is full of pork, those conservatives are totally missing the reason why it won’t work and why it will hurt our economy. What they should be arguing against is the tooth fairy economic principle that “economic health is the product of government spending.” Like all government expenditures, the money comes from one of three places: “by borrowing (which leaves private businesses with a smaller share of the pool of savings for them to borrow from), printing money out of thin air, or direct seizure from the population. Whatever government spends the money on is necessarily arbitrary — government lacks the profit-and-loss feedback mechanism that keeps the private sector from squandering resources and employing factors of production in ways that do not cater to consumer wants.” (One of the provisions in the stimulus bill doles out 100K for new doorbells [Stimulus watch]. The banks wouldn’t want you to not answer your door when they come to take away your house).

Keynesian economists will argue for government spending because we don’t have full employment, therefore there’s “idle resources” out there that need to be stimulated and made productive. But this is a fallacy that Woods rejects. “Pro-stimulus thinkers show remarkably little curiosity about why the so-called idle resources are idle in the first place. They are idle because of some previous entrepreneurial miscalculation. What might have caused systemic miscalculation of this kind? Could it be the Federal Reserve’s manipulation of interest rates, which leads investors to make incorrect assessments of profitability and provokes false economic booms, as F.A. Hayek won the Nobel Prize for showing in 1974?”

Woods then provides a simple example of how a financial bubble like this can happen in the real world and how it needs to be deflated. “Consider a circus that comes to town for a few weeks. A restaurant owner may expand his seating capacity in the false expectation that the circus and the related demand for his food that it brings in its wake will last forever. But when the circus leaves town, he’ll find he has “idle resources” on his hands. We should not want to put these idle resources to work. Doing so would only draw labor and other resources away from other sectors of the economy, where they are employed in the satisfaction of real consumer demand. The expansion of the restaurant should not have occurred in the first place. We should want this bubble activity to shrink back down to size, in order that other, non-bubble activities in the economy can be correspondingly strengthened.”

So how does this example relate to our current economic crisis caused by the housing bubble’s crash? “The artificial housing boom made Americans feel wealthier than they really were. As a result, they consumed more than they would have if the Fed-created housing bubble had not distorted their assessments of their net worth. What the economy needs now, therefore, is not ‘spending’ per se. Too much spending and debt caused the initial problem. People bought more house than they could afford, and on the basis of its seemingly incessant appreciation they went out and purchased more consumer goods than they now realize they should have. Americans are in more debt than they can pay back — credit-card defaults will provoke calls for the next round of bailouts. How can ‘spending’ solve this problem?”

The answer is that it can’t. Debt needs to be liquidated if we want to have a quick recovery. “We should not want to ‘stimulate’ an economy based on debt and overconsumption back into existence. We should want to restructure it along sustainable lines.”

One should also pay close attention to one of Wood’s final arguments. “In his recent press conference, President Obama cited the case of Japan as if it were evidence for his side of the argument. Exactly the opposite is true. Japan has done everything to itself that our government has done and is threatening to do to us, and with no results.” Just like us, Japan lowered their interest rates to 0 percent, spent trillions of dollars to stimulate their economy and in doing so they dug themselves into a hole to become the most indebted country in the developed world. And what did all this government intervention show? THE LOST DECADE in which Japan suffered a 10 year depression throughout the 90’s.

History can teach us a lot of things, but unfortunately we are dooming ourselves to repeat it because of people’s distorted interpretations. If you want to do yourself a favor, read about America’s forgotten depression of 1920 (it lasted no more than a year because the government stayed out). Then compare it to the New Deal and the Great Depression of the 1930’s (it lasted 10 years because the government couldn’t keep their hands off). Then consider the hyperinflation that occurred in the Weimar Republic of post WW1 Germany and Zimbabwe in current times. History is chalk full of examples of how we are screwing ourselves. But sadly this “ostrich nation” is not willing to see it coming.

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