Comments (28)

• fundamentalist

  The feds always use the excuse that a business is too big to let fail. If so, then maybe we should set a limit on how big companies can get.

  Published: September 17, 2008 7:49 AM

• Fephisto

  It is a broken window fallacy on one of the largest scales.

  Published: September 17, 2008 8:33 AM

• KY Leong

  I think it's a Keynesian baggage that the govn has carted along at taxpayers' expense at every turn of trouble. Having arrogated itself the position of market "fixer", it pigheadedly believes that it is always the superior economic manager, always onhand to be the saviour, but always ends up mucking up the works. That's just the character of govn everywhere.

  Published: September 17, 2008 8:42 AM

• Jacob Steelman

  Once again Frank Shostak does an outstanding job of explaining the concept of real wealth and savings which is ignored or worse not understood by the mainstream financial media, the politicians, bureaucrats and even the financial community. It explains what happened to the riches of Latin America and other once wealthy nations that today have become third world countries - wealth was squandered by years of government created (through intervention in the economy, central bank inflation and local wars)malinvestments, looting and thievery. It appears the USA is likely headed in the same direction rapidly now as the government and the Fed take over Freddie and Fannie, Bear Sterns, AIG, and perhaps the US auto industry and who knows perhaps the airlines. This could amount to trillions of dollars and to that extent destroy trillions of dollars worth of real wealth and savings. To paraphrase the late Senator Dirksen from Illinois "a billion here and a billion there and soon you are talking some real money".

  Published: September 17, 2008 8:58 AM

• kcummiskey

  im my own rating agency (kcr) and i give this article a AAA rating.

  Published: September 17, 2008 9:07 AM

• Matt

  Frank Shostack is absolutely correct in his analysis.
  However he does not mention though he knows that the real solution is the abandonment of the Federal Reserve, a private outfit and Fractional Reserve Banking .

  As long as this solution is off of the table the action taken now is only a brief stopgap to give more time to carry on as usual. The FED and the Government will do all in their power to keep this system in place. It must be remembered who the real winners are as long as the FED stays alive, the real winners are Government in that it can continue to spend beyond its means and banks can continue to create debt by Fractional Reserve Banking i.e. lend money that they don't have and charge interest on it. What a racket, everything will be done to keep it going.

  Published: September 17, 2008 9:10 AM

• AC

  read your article, “Are Fannie and Freddie Too Big to Fail?” and agree with your conclusions regarding the intervention of the government into the market system having long term negative effects that the market could have corrected more efficiently if left unhindered. My question for you, in light of the failures on these GSE and the major banks, do you see a need for the government to establish a greater regulatory roll to insure that these intuitions make prudent decisions in terms of risk taking in the future? I realize this would go against free market ideals, but would even slight oversight (if it could remain so) be tolerable and effective in reducing future financial crises involving the level of risk the institutions take on?

  Published: September 17, 2008 11:24 AM

• Michael A. Clem

  Imagine that--another government subsidy on the rocks...

  Published: September 17, 2008 11:37 AM

• Maturin

  Not being an economist, but understanding some basic economic theory from a college intro course many years ago, and being a libertarian by nature, I found your explanation of the FF bailout easy to understand and very cogent. Money versus capital, and the lie that the Federal “Reserve” is actually some sort of reserve resources to save our failing economy, are the key points that are never discussed in any of the standard media channels.

  Could you please write a similar explanation about the latest federal bailout fiasco, AIG?

  Why does it make sense for taxpayers to bail out gamblers (the insurance industry) when they make bad bets and lose?

  Published: September 17, 2008 12:10 PM

• Ohhh Henry

  "Why does it make sense for taxpayers to bail out gamblers (the insurance industry) when they make bad bets and lose? "

  It's like this ...

  There are winners (motivated, hardworking and honest people) and there are losers (unintelligent, lazy, dishonest). The winners do not need government help. They disdain such help because they don't need it, and they know that it would only hamper them if they did get in line for grants, subsidies, protection, etc. The losers love government help, because they see it as easiest and least risky way they can overcome their handicaps and make a good living or even become wealthy.

  People in government, and who want to stay in government, will therefore always lean towards befriending and cultivating losers rather than winners. There is nearly always a ready supply of losers ready to down tools and take up the cry for government help, but if the supply of losers ever does slow down to a trickle, government can always produce more losers - by deliberately tripping up and hampering the winners, with taxes, regulation, and so on. When the rate of increase at which domestic (government-dependent) losers can be created is insufficient compared to the rate at which those in government wish to grow their own salaries and budgets, then a supply of foreign losers must be either found ready-made (for example by taking up the cause of "fixing" African poverty and AIDS), or must be created by using one's armed forces to wreck a country, so that those in and connected to the government can make money on the reconstruction.

  So the answer is, no, encouraging the worst kind of financial management does not make any sense for taxpayers (i.e. winners), but until the whole house of cards collapses it is a perfectly sound and beneficial policy for those in government.

  Published: September 17, 2008 12:41 PM

• Michael A. Clem

  At the risk of running the "No True Scotsman" fallacy, Maturin, I would say that real insurance isn't a gamble. Insurance is supposed to be based upon a homogenous group with a known (based upon statistics, actuaries, etc) amount of risk or losses. They don't know which of their insureds will actually need the insurance and which won't, but they may know, for example, that 20% of their insureds will have accidents that will cost a certain amount for the insurance company. Based on that information, it's easy to charge an appropriate price to cover those costs--it's no gamble at all.
  
  Now, in practice, situations change, and insurance companies have to stay on top of those changes to make sure they continue to charge appropriate rates. Furthermore, the insurance industry is subject to government regulations, too, and these can interfere with providing "real" insurance, and increase the risks to the insurance industry.

  Published: September 17, 2008 1:06 PM

• Eric

  This is a very well written article. I'd say this is maybe one of Frank's best explanations ever. The logic is beautiful, even if the conclusion is not.

  So why is it that all the politicians, sans one, don't understand this, nor any of the non-Austrian economists (and I use that term loosely) either.

  Or is it that they DO understand but realize that when you live in the land of myths, you had better be able to recite the myths with great bravado and sincerity.

  It's always amazing to me just how blind Americans are to the emperor's nudity.
  

  Published: September 17, 2008 1:12 PM

• Mike D.

  Great article Frank. However, the bailout revealed something that was not obvious. Under its charter, FF only issued conforming loans. (Loans in the $300,000 - $400,000 range before the meltdown). This means that FF had no exposure to California and Florida Jumbo Loans, or sub-prime loans that they had securitized themselves. However, FF went out and bought sub-prime jumbo backed securities that had been issued by Wall Street, It is, primarily, the non-performance of these securities that brought them down, not the non-performance of the securities that they issued themselves.
  

  Published: September 17, 2008 1:57 PM

• Paul S. Nofs

  Looking at the M3 money supply numbers and the negative growth numbers for the last two years leaves me to consider that this Insurance Company was caught in the government wealth wasting and looting scheme. They may not have been lazy or indolent. There a million Michiganders suffering that on their homestead. Not all of them were lazy either. Just unlucky that every single Michigan Congressman voted for a deficit then added war spending on top. I guess you can only trust government so far.

  Published: September 17, 2008 1:59 PM

• James R

  Thank you, Mr. Shostak, for a clear and concise repudiation of the "too big to fail" fallacy. This is an excellent resource at which to point people who do not understand how the nationalization of FM ultimately will inflict great harm on our economy.
  

  Published: September 17, 2008 2:24 PM

• Dick Fox

  Frank Shostak at his best! When he stays away from allowing monetarism cloud his thinking (Paul Nofs take note) he is brilliant.

  We all need to start using the term, "Too big not to be allowed to fail."

  Published: September 17, 2008 3:50 PM

• Wladimir Kraus

  While the article makes some valuable points, I have to respectfully but firmly disagree with the particular mode of Mr. Shostak’s analysis.

  Particularly the concept of „pool of real savings”, on which much of Mr. Shostak’s analysis is based, is extremely confusing. In the direct opposition to Mr. Shostak’s thesis, I maintain that there is no such thing as a “pool of real savings” in the real world. There is only savings in terms of money, i.e. people saving and investing money, not some “real wealth”, and there is consumption expenditure, period.
  No one would ever deny that it is the physical structure of production with the many intermediate stages involving the participation of capital goods and labor that eventually brings out a supply of consumers’ goods and which maintain people’s lives and well-being. And we are rightly worried about the ability of the economic system to utilize its available productive resource in the most efficient way and to create a steady and growing flow of real wealth. And it is certainly correct that interventionist policies mentioned in the article do bring about distortions that weaken the ability to produce wealth. However, in order to understand the exact dynamics of the entire process we need be very clear about our analytics.

  In this sense, it’s first of all unclear what Mr. Shostak means by “real savings.” He probably has in mind units of some physical goods. In the previous articles he frequently used the example of backers and shoe-makers who create the “pool of real savings” by not consuming their respective products, bread and shoes. The trouble is that this “model” corresponds to no real facts whatsoever, even approximately. The fact is that no one ever contemplates his saving/investment and consumption decisions in terms of goods that he produces, or helps to produce. Every single participant in the division of labor is concerned only with money receipts and money outlays. He simply can’t do otherwise. There is nothing “deeper” to it, beneath the monetary exchange.

  Second, and closely related, it is Mr. Shostak who fails to properly distinguish capital value from capital goods and how they are related to each other. Business firms invest money to buy capital equipment, tools, materials and implements. The extent of the investment, on the level of the economy as a whole, determines the relative proportion of the demand for capital goods to the demand for consumers’ goods which strongly correlates with the strength of the capital goods industries relative to consumers’ goods industries. More money invested in capital goods industries means deeper capital intensiveness, which in turn translates into greater current production of capital goods relative to consumers’ goods with the final outcome being a greater supply of consumers’ goods (real wealth) in the future. Admittedly, this very brief description is very crude but it nevertheless captures the essence of the production process, of the role of spending of certain kinds in maintaining and enlarging the existing capital structure. No confusing concept “real savings” is needed to describe the process.

  The real savings confusion affects Mr. Shostak’s assessment of the present very serious condition of financial markets too. He admits that letting the big players go under will create unemployment and hardships but, astonishingly, he simply regards it as necessary evil. He seems to forget that we are talking about massive waves of business bankruptcies, enormous dislocations in and destruction of the capital structure, the massive loss of real wealth, quite possibly even more direct government intervention. Letting things go under freely where there is no “free market” in wages and prices will inevitably lead to disastrous consequences for the real economy.

  The situation is indeed very serious and it needs careful thought and a very sensible approach, but above all we need a correct understanding of the events. Unfortunately, Mr. Shostak’s “real savings” analysis is not at all suitable for the purpose.
  

  Published: September 17, 2008 4:48 PM

• Kevin B

  Wladimir Kraus: "He admits that letting the big players go under will create unemployment and hardships but, astonishingly, he simply regards it as necessary evil."

  The evil lies in the forced bailout of the big "players" by the smaller ones. If the smaller players were to voluntarily aid the larger ones, it would be a different matter, but the fact of the matter, that individuals are being forced to cough up resources for the purpose of saving any particular cause, demonstrates blatant economic inefficiency.

  Published: September 17, 2008 5:52 PM

• Judd Rusnak

  Vladimir, you are wrong and Dr. Frank Shostak is right, as simple as that.

  Money can be derived from only two sources, either it was saved by individuals and/or corporation or it was printed/taxed by the governments.

  Now, if it was supplied by saved resource meaning “Pool of funding”, it is OK.

  But, if it was the result of diluting the real wealth of the nation, either printed by governments, or via taxing the people and passing it to the gamblers, who just borrowed paper from the banks – which I would call it as government forgery, knowing fully that they can not repaid, when market conditions have changed, it is nothing but a thievery.

  So do apologize to Dr. Frank Shostak, you just don't understand the simple concept of “Pool of funding”.
  

  Published: September 17, 2008 6:14 PM

• Judd Rusnak

  Vladimir, you are wrong and Dr. Frank Shostak is right, as simple as that.

  Money can be derived from only two sources, either it was saved by individuals and/or corporation or it was printed/taxed by the governments.

  Now, if it was supplied by saved resource meaning “Pool of funding”, it is OK.

  But, if it was the result of diluting the real wealth of the nation, either printed by governments, or via taxing the people and passing it to the gamblers, who just borrowed paper from the banks – which I would call it as government forgery, knowing fully that they can not repaid, when market conditions have changed, it is nothing but a thievery.

  So do apologize to Dr. Frank Shostak, you just don't understand the simple concept of “Pool of funding”.
  

  Published: September 17, 2008 6:14 PM

• Eric

  "Real funding" is simply what Frank regards as stuff. You know, things like, tv's autos, buildings, machines etc.

  Money is NOT wealth. And here we see the error in thinking that is so prevalent. I don't know how many times people I've talked to have confused money with wealth - as WLAD above is doing.

  Consider 2 scenarios.

  1. Tomorrow, a huge (fill in your favorite catastrophe e.g. earthquake) that destroyed all the buildings and automobiles and everything except money in the entire world.

  2. The same thing happens and destroys all of our money (e.g. all banknotes catch fire or some such event plus all checking accounts are zero'd by a computer bug).

  Which would cause bigger suffering?

  That's the difference between money and real funding. In the first case, we'd all be suffering and probably all die of starvation or exposure in a few weeks. But we'd be rich suckers with all the paper money we can handle - just nothing to buy and nothing to help us survive.

  If we only lost all of our money, sure there'd be plenty of suffering as we tried to figure out who owes who what, but at least we'd have a place to live, food to eat, cars to drive, machines to use to fix the computer bug.

  In one case we could at least barter, in the other case we'd have wheelbarrows full of cash that all we could do was burn to keep warm in the dismal winter to come.
  

  Published: September 17, 2008 6:42 PM

• george

  The gov't reaction has been so quick that a real mess must exist and failure is imminent. They are just protecting their friends so the Ponzi scheme can go on longer.

  Stop thinking of banks and investment houses as capitalist enterprises they are agents of the government just like defense contractors. Unlike defense contractors they get away with unconscionable self-rewards hence the Agency problems. Defense contractors actually deliver products: planes tanks, bombs etc.

  It is about time these agents got reigned in, which will only occur by letting them fail and to build free from the wreckage.

  Bankers dress and act conservatively to disguise the risky and dangerous things they are doing with other people's money.

  Nothing free market about this train wreck it is classic malinvestment.

  The Fed is like a plane that is in a dive, but has exceeded wing speed, the pilot can pull back on the stick and pull the wings off, or continue in a dive. Both paths lead to the same destination, ending in a rude stop.

  "Never let a banker go."
  ~Dan Aykroyd

  Published: September 17, 2008 7:35 PM

• Judd Rusnak

  Eric, money is WEALTH as we have transformed tv’s, autos, etc. into MONEY.

  We replace the goods with money and money with goods, this just the mechanism we use today for conducting any business transactions.

  The problem is that governments are creating money out of “thin air”, allowing the so called entrepreneurs to exchange thin air to goods and good to thin air, knowing they might loose when condition in the market are changed.

  If governments did not printed money (out of thin air), and the market was free of bludgers who suck the banks dry out of that supply of “money for gambling” (as real estate, stock market, etc.), we would not be in a mass we are in today (AIG, FF, etc.).
  

  
  

  Published: September 17, 2008 8:11 PM

• Judd Rusnak

  Let me add that today’s borrowing is based on money available from the banks via the Reserve Banks money supply which is based on printed "out of thin air" or "tax collected" and not based on "real pool of funding".

  Published: September 17, 2008 8:26 PM

• Greg

  I just wanna know where da gold at!

  Maybe we can sell Iraq to China, get back on the gold standard and everything will be fine.

  Published: September 17, 2008 10:18 PM

• KY Leong

  W Kraus will need to do some serious homework on Austrian theory of money and the ABCT before he can properly appreciate what Dr Shostak means by a "pool of real savings". I'd suggest Mises' "Theory of Money & Credit", Hoppe's "Misesian Case against Keynes" and Rothbard's "What Govn has done to our Money". Until he does, he'll always end up sounding like the many "educated" economists churned out in hoards by the mainstream (statist) establishment colleges.

  How else can we make him understand that it IS the govn, abetted by the Fed for decades (incessantly creating fiat money out of thin air) who is the real culprit behind the present banking/financial debacle? And the many crises/scandals that came before, and always "fixed" at taxpayer's (read: real producer/saver) expense?

  Like many others in this thread I want to thank Dr Shostak for this excellent and highyl illuminating piece which has been written with so much clarity and precision, which is not something we can say for much of the "mumbo jumbo" one encounters in the mainstream media and academia nowadays.

  Published: September 17, 2008 10:21 PM

• Eric

  Judd, Rothbard explains the difference between money and everything else in "the case against the fed". It's this everything else that I would define as being wealth.

  Wealth bestows benefits on society. More wealth, more benefits.

  However, money is unique, in that more money in the world changes nothing. It's no different than magically putting extra zeros on the end of every banknote evenly at say midnight and everyone knows of the change. Would adding Just 1 zero make the entire world ten times wealthier overnight?

  I'm sure you would agree that the answer is no, we're no better off by a sleight of hand.

  This is not to say the act of creating money and unfairly distributing it does nothing, just that more or less of it when held constant doesn't change our overall wellbeing. More stuff does. And that's why money is different than wealth.

  Here's a section of the book, and the url for the book online,

  http://mises.org/books/fed.pdf

  
  The Genesis of Money

  
  It is impossible to understand money and how it functions,
  and therefore how the Fed functions, without looking at the
  logic of how money, banking, and Central Banking developed.

  (here's the key point)

  The reason is that money is unique in possessing a vital
  historical component. You can explain the needs and the
  demand for everything else: for bread, computers, concerts,
  airplanes, medical care, etc., solely by how these goods and
  services are valued now by consumers. For all of these goods
  are valued and purchased for their own sake. But "money,"
  dollars, francs, lira, etc., is purchased and accepted in exchange
  not for any value the paper tickets have per se but
  because everyone expects that everyone else will accept
  these tickets in exchange. And these expectations are pervasive
  because these tickets have indeed been accepted in the
  immediate and more remote past. An analysis of the history
  of money, then, is indispensable for insight into how the
  monetary system works today.

  Published: September 18, 2008 3:04 AM

• Mike

  Thank you for a great article that will reach far too few readers among policy makers, the media and tax paying public.

  Published: September 18, 2008 12:23 PM