All Commentary
Wednesday, June 1, 1988

The Crash of 1987: An Excuse for Government Intervention?

John Semmens is an economist with the Laissez Faire Institute, a free-market research organization headquartered in Tempe, Arizona.

On October 19, 1987, the U.S. stock market suffered its largest single-day loss in history. The 508-point drop in the Dow Jones Industrial Average was five times greater than the worst previous drop. In percentage terms, the 22 per cent decline exceeded the worst day of the infamous 1929 stock market crash.

If the market were free from government interference, a decline in stock prices wouldn’t pose a serious threat to the economy. Of course, there would be need for some adjustment, as infeasible investments were liquidated and prices fluctuated to clear the market. But there would be no cause for great alarm.

Unfortunately, however, the market isn’t free from government interference. In fact, government manipulation of the quantity of money and credit is a prime cause of speculative booms and busts in investment markets. The dramatic rise and fall of the stock market in 1987 surely was abetted by the Federal Reserve’s actions to accelerate, then decelerate the growth in the money supply.

A critical danger at this point is that the stock market crash and the economic adjustments which must follow will serve as an excuse for further government intervention. As Robert Higgs points out in his recent book, Crisis and Leviathan: Critical Episodes in the Growth of American Government (Oxford University Press, 1987), crises, real or contrived, provide a convenient excuse for the expansion of government and the suppression of individual freedoms.

The crash of 1929 need not, by itself, have resulted in the Great Depression. However, the policies applied to a faltering economy by the Hoover Administration, Congress, and later, the Roosevelt Administration, stifled market adjustments and plunged the nation into a prolonged economic contraction.

President Hoover, acting under the mistaken idea that high prices mean prosperity, urged businesses not to adjust to economic changes. Firms were persuaded to refrain from lowering prices and wages and from liquidating malin-vestments. Not surprisingly, widespread failure to adjust worsened an already bad situation.

While President Hoover was arguing against adjustment, government policies in the monetary, fiscal, trade, and regulatory arenas were sabotaging rational business and consumer responses to the changed environment signaled and precipitated by the stock market crash of 1929. On the monetary front, the Federal Reserve engaged in manipulations of the money supply that resulted in a 30 per cent decrease in monetary reserves over a three-year period. On the fiscal front, Congress enacted huge tax increases, while simultaneously appropriating funds for wasteful boondoggles like the Reconstruction Finance Corporation. Meanwhile, international trade was dealt a crushing blow by the Smoot-Hawley Tariff Act of 1930. Finally, a program of government harassment and meddling with the marketing and employment practices of business was to become the mainstay of the new Roosevelt Administration through its alphabet soup of new Federal laws and agencies like the NRA (National Recovery Administration), the AAA (Agricultural Adjustment Ac0, and the NLRB (National Labor Relations Board).

What Not to Do

The crash of 1929 and the disastrous government policy responses over the ensuing years could serve as an example of what not to do in the wake of the crash of 1987. The deleterious effects of the policies chosen in the earlier era could be a useful warning of the hazards to be avoided. Tragically, it seems more likely that the errors of the past will be repeated. Government seems poised to duplicate the policies that led to so much hardship in the 1930s.

Monetary manipulation is, if anything, more entrenched as a policy now than it was in the 1920s and 1930s. in recent years, many devotees of this manipulation confidently asserted that Federal Reserve authorities would take action to assure rising stock prices through the election of 1988. The bursting of this bubble of optimism in October of 1987 has done little to diminish the manipulators’ confidence that monetary authorities will prevent an economic recession from occurring prior to the 1988 election. The notion is that the Federal Reserve will create enough money to maintain purchasing power.

Life would indeed be easy if the mere creation of money could increase purchasing power. The harsher reality is that only production can create real purchasing power. The creation of money only achieves the transfer of purchasing power from the productive to those favored by access to the easy credit provided by the monetary authorities. The productive elements of the economy are penalized by having some of the real value they have produced, in effect, stolen from them via exchange for inflated money. The financial capacity to regenerate the next round of production is reduced by this process. The growing awareness of the expropriation effected by money creation diverts erstwhile productive endeavors to actions aimed at minimizing the damage of inflation. The result is lower real output and lower real purchasing power.

Inflating the money supply and depreciating the dollar’s purchasing power is a government scam that has been perpetrated for decades. It enables the government to avoid paying back the full value of the funds it borrowed from those who bought its bonds. The expectation that an acceleration of this scam will produce prosperity is a dangerous fantasy. The fear that the desperate circumstances facing the U.S. government will prompt runaway inflation has already sparked a “run” on the dollar in the international marketplace. The likelihood that other governments will retaliate with inflations of their own (thus repeating the rounds of com- peritive currency devaluations of the 1930s) threatens to spread the ill effects of monetary expansion into a worldwide epidemic.

Coping with the declining real purchasing power engineered by inflationary monetary policy will not be the only problem confronting businesses and consumers. Governments at Federal, state, and local levels are bent on intensifying the fiscal burden on all taxpayers. Despite the widespread awareness of the huge amounts of waste in government budgets (the Grace Commission spotted $140 billion per year at the Federal level, alone), there are no plans for significant cuts in spending. Neither the highly publicized compromise plan announced by Congressional and Administration conferees in December, nor the Gramm-Rudman sequestration process, invoke any actual net reductions in Federal spending. Under either approach, Federal expenditures for the current year (or any other year covered by either approach) still will continue to grow. The highly touted “cuts” consist solely of a slowing in the rate of increase in government spending. In fact, all of the “cuts” in spending during the Reagan years have amounted to nothing more than a slight slowing in the rate of growth in Federal outlays. Even at this slowed pace, Federal spending has still grown faster than the rates of inflation and population growth combined.

While still continuing to increase spending on blatantly wasteful programs, politicians are furiously concocting schemes to expropriate more resources via tax hikes. The search for a so-called “painless” tax, of course, is an exercise in futility. There are no taxes that have no negative impact on economic activity. Whatever is taxed will be discouraged.

The quaint notion that corporations can be made to bear more of the burden, thus sparing hard-pressed individuals, is the most alluring delusion of the tax-raisers. To survive, corporations must cover all costs—including taxes—from available cash flow. Increased taxes must be covered by higher prices to consumers, re ductions in other operating costs (for example, wages), or smaller profits. Real human beings will bear the brunt no matter how the costs are distributed.

To many proponents of higher corporate taxes, the prospect of smaller corporate profits appears the most acceptable outcome. Some tax bills even attempt specifically to target corporate profits and to bar the sharing of the burden with consumers or employees. Even if the full burden of the tax could be nominally restricted to corporate profits (a doubtful undertaking, at best), a tax that is effected via a reduction in corporate profits will tend to reduce stock prices. A further lowering of stock prices would aggravate the problems caused by the initial crash—the emergency used to support the call for government action in the first place. Lower stock prices will mean businesses will have a harder time acquiring capital. Making it harder for businesses to acquire capital will not help to relieve recessionary conditions.

The refusal to accept real reductions in government waste, and the insistence on increased taxes, will place even greater burdens on a weakened private sector. Thus, while scarce resources will continue to pour into redundant military bases, agricultural surpluses, money-losing rail passenger service, public project cost- overruns, welfare fraud, and other “essential” expenditures, funds for private-sector business purposes or consumer purchases will be severely curtailed. The ramifications of this chain of events are further business contraction, lower output, more unemployment, lower tax collections, more filings for unemployment compensation and welfare. If the private, productive sector must bear the total burden of an economic decline, the economy could be sentinto a downward spiral that would be difficult to reverse under government’s determination to tax and spend.

At the same time that government is prepared to deal the private sector a one-two punch composed of monetary inflation and fiscal profligacy, it is also proposing to preserve and protect American industry by imposing punitive trade barriers on imports and by offering to formalize government/business/labor partnerships through industrial policy initiatives.

Avoiding the Blunders of the Past

Trade barriers played a critical role in deepening and prolonging the Great Depression of the 1930s. Apprised of this, you would think current policy-makers in government would steer clear of so obvious a blunder. Unhappily, it seems that repetition of the blunder cannot be ruled out. The assertion of trade barrier advocates is that this time is different. When the Smoot-Hawley tariff was enacted in 1930, the U.S. had a trade surplus. Now, the U.S. has a trade deficit. However, the whole trade surplus versus deficit issue is an arbitrary concoction that has little relevance to actual business dealings.

Trade takes place because each party to a transaction willingly exchanges something he has for something he wants. Therefore, trade is always in “balance.” Adding up and comparing the flows of merchandise, while excluding the flows of cash or financial assets, as the conventional balance-of-trade calculation does, is an exercise in self-delusion. There is no reason to expect the flow of merchandise ever to be in balance, much less for it to balance in any fiscal year. Nor is it the case that a surplus is “favorable” and a deficit “unfavorable.” Attempts to engineer a reduction in imports in order to produce a more favorable balance of trade are more likely to impede efficiencies and lead to unfavorable results for all trading panners.

Regardless of how self-destructive trade bar-tiers are, any U.S. action to block imports is almost certain to generate so-called retaliation. That is, if the U.S. government acts to prevent U.S. citizens from buying cheaper foreign goods, foreign nations will retaliate by barring their citizens from buying cheaper U.S. goods. The most efficient producers in each nation will be the ones hurt the most. Harming the most efficient firms in world commerce will raise the cost of living for the people of each affected nation. This will reduce real purchasing power and promote economic hardship.

Even if other nations are sensible enough not to retaliate, the U.S. still will be harmed by erecting import barriers. Barring U.S. businesses and consumers from acquiring goods from the most efficient producers in the world will obstruct efficiency and prosperity in America. U.S. businesses will be forced to substitute second- best, more costly inputs in the production process. The final output will be of lower quality and higher cost. This will fur-tiler diminish the competitiveness of U.S. rums in the international marketplace. Consumers of American-made products will be forced to pay more in order to get less. While it is true that government- mandated trade barriers will help some firms and individuals, the net impact for the economy, as a whole, will be negative.

There are some advocates of trade legislation who aver that barriers are not intended as a policy, but, rather, as a threat. Once foreigners become convinced that the U.S. is bent on a punitive course, it is argued, they will take steps to remove some of the trade barriers they have in place against American exports. Such a “doomsday” sort of threat must surely denote a state of confused desperation in U.S. government policy-making circles.

Sound economic analysis has long demonstrated that trade barriers are damaging to the economies of the nations that impose them. If two centuries of evidence and logic have failed to prevent or remove existing trade barriers, we can hardly be sanguine about the chances for removing barriers by first threatening to increase them. It will be of little comfort to the average American to know that others probably will suffer as much, or more, from the mutual stifling of international trade that is likely to result.

The most irresponsible position on trade barriers is demonstrated by those who court partisan political advantage by supporting legislation that they hope will be killed by someone else. Import barriers are proposed by those posturing as friends of American industry and labor. The proposers of import barriers portray themselves as persons willing to do something about the trade problem. Though they know that the import barrier “cure” is pure poison, the plan is to denounce anyone who would dare to be more responsible by opposing this remedy. Thus, the political support of key special interests can be curried while the disastrous bill is defeated by “do-nothing” Congressional colleagues or vetoed by an “insensitive” President. In the unhappy event that no one is courageous enough or potent enough to block trade barrier legislation, then no one will be to blame because everyone went along. Disasters enacted by consensus are politically safer and, therefore, preferred by officeholders whose highest priority is re-election.

As bad as trade barriers are, their potential for mischief and abuse could easily be exceeded by “public-private partnerships”—collaboration among business, government, and labor in making decisions on production, hiring, marketing, distribution, and the like—established through so-called “industrial policy” initiatives. The force which disciplines the private sector and ensures its attention to customer service and efficiency is competition in the marketplace, it is the fear that rival producers will do a better, more cost-effective job of serving customers that stimulates private sector firms to improved performance. In contrast, the monopolistic, noncompetitive, tax- supported public sector is legendary for its inefficiency and indifference to customer service.

A “Partnership” with Government

“Helping” U.S. businesses by joining them in partnership with government would be akin to expecting a sprinter to run a better race as a member of a chain gang. The federal government, remember, is the operation with at least $140 billion per year in waste. The federal government loses money on virtually every undertaking it attempts. The federal government is unable to dispense with anachronisms like the Tea-Tasting Board. The federal government pays $600 each to buy hammers for the Pentagon. Partnership with these guys is going to make American industry more competitive and vigorous?

Enmeshing the private sector with government industrial policy holds no prospect for salutary consequences. Finns are apt to become bogged-down in red tape or in schemes to fix prices or tap into the public treasury. Attention to cost is likely to atrophy. Competition will be undermined. Customers will fade in importance relative to bureaucrats and legislators. Real output cannot help but suffer.

By this time, readers will have noted that the current menu of policies for dealing with the difficulties facing the U.S. economy bears an unpleasant resemblance to policies adopted during the Great Depression of the 1930s. We know better; but lust for power and the desire to use government to obtain resources that cannot be earned seem to be more potent motivators than knowledge and reason.

When this country plunged into the Great Depression, the dead-weight burden of excessive government was only a fraction of what it is today. In order to get elected, Franklin Roosevelt at least had to promise to rein in the spending taking place under the Hoover Administration. Today, not even a pretense of fiscal responsibility is considered necessary by those seeking elective office. In this respect, the future looks exceedingly grim.

On the positive side, the U.S. economy is wealthier than it was in 1929. Them is more of a cushion between our current standard of living and the rock- bottom that was hit by many people in the 1930s. This gives us a little more margin for error. At the same time, though, the public sector and the private interests that feed off public funds are much more voracious than 50 years ago. The higher level of wealth enjoyed today could mean that the drop to rock-bottom will be steeper and deeper this time around.

If we are to avoid this steeper and deeper depression, we will need to pursue policies diametrically opposed to those currently being touted. Instead of monetary manipulation and inflation, we need a dollar that preserves its value and purchasing power. Instead of more government spending and taxing, we need substantial reductions in government expenditures and we need real tax cuts. Instead of a suicidal program of trade barriers, we need to remove all impediments to the efficiency gains of specialization and comparative advantage that naturally flow from free trade. Instead of a stuporous partnership between public and private sectors, we need less interference by government in the workings of a competitive marketplace.

Knowing what needs to be done and getting it done through the political process are two different things. Whether the nation avoids repeating the policy mistakes of the past remains to be seen.

  • John Semmens is a research fellow at the Independent Institute and research project manager in the Arizona Department of Transportation Research Center.