By Jay Schweikert, J.D. 2011

After many years of disappointment, the House of Representatives has finally delivered on the promise of representative democracy. Yesterday, in an act of shocking political honesty, the House rejected President Bush’s $700 billion Wall Street bailout, a plan designed to protect and promote the idea that men, companies, and nations are free to act without regard to the consequences of their actions. I may be overly optimistic about the reasons for the House’s decision, and it may turn out that a slightly different political compromise will be sufficient to push the bill through. Nevertheless, one thing is clear: the politicians depending on the illusory prosperity of the bailout for their electoral bids this November had a wrench of truth thrown into their machines, and I can’t help but smile at that.

The story that we have been told about the cause of our recent “financial crisis” is the same story that proponents of centralized government planning have been telling us at every successive problem for over a century: unregulated capitalism is out of control. We have heard that unregulated financial markets have encouraged wildly irresponsible speculation. We have been told that the only solution is to have the government (that is, the taxpayers) foot the bill and usher in a whole new set of regulations to ensure that banks remain accountable to the “public good” (or at least to those that claim to speak on its behalf). This is the exact same story that New Deal regulators told us at the height of the Great Depression, and it is based on the exact same lies.

Whatever may be open to disagreement, the following is not: neither the stock market of 1929 nor the financial institutions of today exist in a free market. Democrats in particular have been quick to point out the financial regulations that were lifted in the 1990s. But no major politician from either party has even bothered to mention the single most powerful regulatory institution in our government – the Federal Reserve. It is astounding that our nation, despite having thoroughly discredited wage and price controls, can still take government regulation of the price of money for granted. This is, of course, exactly what the Fed does and has been doing since 1913.

Through open-market operations (the buying and selling of bonds), the Fed artificially adjusts the nation’s money supply and provides indirect control over interest rates. The belief underlying this system was that if the government could control interest rates it could “fix” the business cycle and ensure continuous economic growth, regardless of actual market conditions. The truth, of course, is that temporary recessions are not harmful but beneficial. They represent the market correcting its errors and returning to a healthy state. Interest rates go up when lenders become concerned that their money is being used in overly-risky investments, which leads them to demand a higher return before financing future ventures. Bad assets get liquidated, firms that were engaged in unprofitable ventures go out of business, and the market returns to a productive level of output.

The problem is when the Fed follows an “easy credit” policy in an effort to ensure everlasting growth. Instead of letting interest rates rise to correct for bad investments, the Fed prints money and buys bonds, thus providing a downward pressure on interest rates and encouraging more risky investments. In the short run, this can create the appearance of prosperity because the immediate effect is to expand investments rather than curtail them. (The “wild speculation” of the 1920s was due precisely to this kind of regulation, not any natural flaw in free capital markets.)

However, reality eventually catches up with all systems, and the question is only how devastating the results will be when it does. The Great Depression is a testament to how bad this can be, but it is also a testament to what happens when we refuse to identify the actual causes of such problems. No honest economist can deny that the wage and price regulations of the New Deal only made the Depression longer and more severe, yet our society persists in the absurd notion that capitalism somehow “caused” the Great Depression and that socialism “fixed” it.

We are seeing the exact same pattern repeat today. Capitalism is being blamed for encouraging bad investments when in fact the incentives for these investments came from the Federal Reserve and other regulations effectively promising that the government (again, the taxpayers) would make good on bad debt. Instead of recognizing the true cause of the problem, politicians are mumbling about the need for more regulations and proposing a bailout plan specifically designed to keep the bad assets from being liquidated and to keep prices from dropping to their market levels.

The political incentive for this plan is quite clear, of course. The appearance of prosperity right before an election is a goldmine to anyone seeking office, and most citizens lack sufficient knowledge of the Fed to question their representatives. If the political motivations for this plan were not clear enough, observe the frenzy with which both major parties and their candidates blamed each other for the failed vote in the House rather than address substantive concerns with the bill. It is certainly true that there will be costs regardless of what ends up happening. Without the bailout, we should expect a mild recession for perhaps a year. But the doomsday scenario that all of our major politicians are threatening us with if we do not pass their bill is exactly what we can expect if we do continue to go along with their plan. I cannot say what led the House to put the brakes on this scheme, but I can only hope it lasts. Otherwise, the only thing we have to look forward to is a giant “I told you so”.