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Assessing the Damage

September 21, 2001

Tags Legal SystemU.S. Economy

As documented by Robert Higgs in Crisis and Leviathan, the state uses any crisis, even those it brought about itself, to enhance its power. Economic crises are no different in that respect: The Great Depression ushered in a vast new array of government powers and programs, and the inflation of the early 1970s led to a brief flirtation with wage-and-price controls.

So, it is no surprise that in our current crisis we see economic fallacies calling for "temporary" government interventions in the economy popping up like mushrooms after a rain.

One of these fungi is the notion that we must subsidize the airline industry to keep all of our airlines from going bankrupt. Last Sunday, House Majority Whip Tom DeLay, R-Texas, issued a statement calling for a bailout:

"We've got to stabilize the major airlines with federal assistance. The airlines are a national economic asset and if they spiral into bankruptcy, our broader economy will suffer unacceptable damage."

Well, under the supposition that we live in a free market economy, the airlines are not a national economic asset -- they are the owners' economic asset. It is the owner's job to evaluate the state of that asset, and, using his entrepreneurial judgment, see that it remains an asset. One part of doing so is to ensure that there are adequate reserves to run the company through a crisis. It's obvious that a company like Midway Airlines did not have enough in the way of reserves. That is unfortunate for the owners, but it is also simply the nature of a market economy that competition will judge that some suppliers are inadequate to the task they have undertaken.

It is, of course, possible that the demand for air travel will drop to the point that the American market cannot support even one domestic airline. This seems very unlikely. However, if it did occur, then we genuinely don't need airlines. If no one wants to fly enough to make running airlines profitable, then keeping airlines operational is purely a welfare program for the owners and employees.

Perhaps some people feel that a home in some remote mountains is now a more valuable asset than is a flight to Disney World. Are they wrong about this? What sense does it make to tax them to support airlines offering flights they don't want to take, thereby preventing them from buying that mountain home? Well, we suppose if you hold a lot of airline stock it makes sense.

The "support the airlines" campaign meets the second of our fallacies, which we can call the "just-buy-something fallacy," in the writing of Virginia Postrel, who has issued a "call to buy airline tickets even if you don't need them…"

Now what possible economic purpose can be served by having people who don't intend to fly supporting the price of air travel? The essence of this recommendation is not different from the Roosevelt administration's purchase of agricultural products in order to destroy them. (By taking a seat on an airplane you have no intention of using, you have destroyed a little bit of the capacity for air travel.)

And just how long can people afford to keep buying empty seats on planes? If people's willingness to fly has dropped, the airlines must adjust to this fact. Some of them will survive, and some will not. Delaying this adjustment only wastes resources, and a crisis is the last time to waste resources.

The general call to simply consume something, whatever it is, to "support the economy," has also been circulating around the Internet. But the average person's instincts are absolutely correct in this case: A crisis is an occasion for hunkering down and saving, not for wild spending for consumption. If we are really at war, what do the "pundits" think we will gain by our shopping spree? Will we defend ourselves with knick-knacks bought from The Home Shopping Network?

No, a society comes through a crisis because it has something in reserve. And what are needed to rebuild once the crisis has passed are more reserves. The World Trade Center cannot be rebuilt with restaurant dinners and weekend vacations: It will take massive capital investment, which depends on saving.

Another fallacy that sprouted after the attack was the notion that the closure of Wall Street was necessary to allow investors to "catch their breath" and "consider the situation." The idea was that, had the market remained open, panicked investors would have irrationally dumped their stocks and thereby damaged the economy even further. Over the weekend, news reports tirelessly explained the "protective" mechanisms that would check a precipitous decline on Monday: If the Dow drops 10% by a certain time, the NYSE closes for one hour; if it drops 20%, the market closes for two hours, and so on.

But does this analysis stand up? After the World Trade Center towers collapsed, the damage had been done. (We are, of course, neglecting the opportunity costs of re-directing rescue workers and resources from other pursuits.) The immediate response of the city was to assess the physical damage and see if any lives could be saved. It would have been downright criminal for the Mayor to seal off the crash site for several days in order that everyone could "reflect" on the tragedy and not respond "emotionally."

In the same way, investors needed to know just how badly the economy was affected by the attacks, in order to restructure capital allocation as best they could in light of the new circumstances. Rather than the aggregates that so worried analysts, the crucial problem was how individual firms had fared. Only by allowing shareholders to freely trade their assets could the pricing function of the market be useful; the old prices of airline stocks, for example, were completely irrelevant. Those making business decisions during the six days following the attack (before Wall Street had reopened on Monday) were completely in the dark, and had to operate much as Soviet-era producers. Of course, to the extent that Wall Street was physically unsafe for business, then the closure was justified, but nonetheless costly for the reasons given above.

And what of the NYSE trading curbs, designed to nip a crash in the bud? Discussion of such mechanisms usually depicts traders as simple automatons, who blindly follow a few rules of thumb. It does not occur to most analysts that investors are fully aware of the trading curbs and will adjust to them. Knowing the market will be closed if it hits a certain threshold, many cautious investors might sell earlier than they otherwise would have, in order not to get stuck holding the bag.

This possible effect can be illustrated with an analogy. Suppose Mayor Giuliani sought to protect the supply of bottled water after the crash, and announced at a press conference, "If the supply of bottled water on grocery shelves drops 10%, the police will close all stores for one hour." Many people wouldn’t even wait for the end of his sentence; they’d be running to the store.

In the business of cultivating economic fallacies, supply-side economist Lawrence Kudlow seems to be running his own mushroom farm. In the NY Post, Kudlow suggested that the destruction of the WTC would be a boost for the economy, citing the "broken window effect" to back his argument. Of course, as William Anderson points out, there is no "broken window effect" but rather a broken window fallacy, and Kudlow's argument is an instance of that fallacy.

In another article, this one for NRO, Kudlow says:

If millions of Americans each buy 100 shares of their favorite stock or investment fund on Monday, the winners will easily beat the losers at the closing bell. For all those around the country who want to help the families of the victims, help rebuild the economy, and help in the war against despicable terrorism, buying shares would be an incredibly positive step.

Let's forget about whether Kudlow's plan was remotely practical. Was it a good idea if it could have worked? If people drive the price of stocks higher for patriotic reasons, does this somehow help the nation?

Let us consider, for a moment, an economy in which the price of farm products is declining. Farmers may begin pleading for the government to stop the price drop. "Wealth is being wiped out of the economy," they will complain, "the value of our farms has fallen 50% in the last year. This makes everyone poorer, since we can't spend as much." This reasoning makes their pleas seem to be for the good of the whole nation, not just a matter of self-interest.

Surely, any free-market economist would debunk this wrong-headed thinking. Wealth has not disappeared from the economy at all! The same farms, the same fields, the same tractors are here today as were there last year. If some farms have shut down, it is only because they were economically unnecessary.

All that we definitively can say has occurred is that there has been a change in relative prices. A bushel of wheat buys fewer dollars, but the flip side of this that a dollar buys more wheat. Those holding wheat are hurt, but those holding dollars, or any other good which did not decline along with wheat, are helped. This constant adjustment of prices by market participants, so as to bring supply and demand into balance, is the essence of the market process.

Beyond pointing out this most elementary of economic facts, there is little further we can say about whether "everyone" is better off with the new price configuration than they were with the old one. Certainly, though, we can point out that it will not do to try to maintain the old prices by government manipulation in the face of the new data of supply and demand.

But many people, such as Kudlow, who have no problem with a fall in the price of wheat, will rail against any fall in stock prices, urging crackpot schemes and government interventions to stop the decline. When stock indices fall, we hear repeated worries that "wealth is being wiped out." On the surface, this seems too obvious to argue. With the NASDAQ, S&P, and Dow plunging, it looks as though this wealth has simply vanished into thin air.

This view is the result of confusion between the money prices of goods and the amount of wealth in the economy. Unlike the terrorist attack, the market decline has not leveled any buildings or rendered any machines inoperable. America is just as full of farms, warehouses, railroads, and oil wells as it was the day after the attack, when the market was closed.

Freely established market prices are not arbitrary; they serve a definite social function. At any time, the current market price of a share of stock reflects the best estimates of experts—where "experts" are those who have demonstrated the greatest foresight in the past—of the future price of this share. Any news darkening the future prospects of a business will invariably reduce that company’s share price. This is vitally necessary, in order for the market to accurately price the company itself. Any perceived arbitrage opportunities, where news has not been taken into account in a company's current stock price, quickly will be bid out of existence. A critic of a price movement is implicitly asserting that he knows better than those actually risking their own money to support their convictions do.

Before condemning a general fall in the stock market, it seems we ought to ask, "Why has the stock market plummeted?" The answer to this question demonstrates why any interference with the process is harmful. Sometimes it is argued that a fall in stock prices is simply a case of an "irrational," self-fulfilling prophecy. But to the extent that this is true, the real wealth of the economy (as argued above) has not changed.

But what about our present case, where the stock market plunge is due to something more fundamental than mere sentiment? In that case, the euphemism "correction" is accurate. People realize with dismay that the stock prices that existed as of the day before the terrorist attack no longer reflect the value of the underlying assets. However, the decline in stock prices is merely the symptom of economic damage, not its cause. It should be clear that the great destruction that occurred on September 11 could not possibly have enhanced the value of US corporations. There is no sense in pretending that damage has not been done.

As Ludwig von Mises said in Human Action:

It is easy to understand why those whose short-run interests are hurt by a change in prices resent such changes, emphasize that the previous prices were not only fairer but also more normal, and maintain that price stability is in conformity with the laws of nature and of morality. But every change in prices furthers the short-run interests of other people. Those favored will certainly not be prompted by the urge to stress the fairness and normalcy of price rigidity.

The price signals provided by a free market are never as much under fire, but never more important, than in a time of crisis.


Gene Callahan is author of  Economics for Real People, forthcoming from the Mises Institute. See his Archive or send him MAIL. Robert P. Murphy, a Rowley Fellow of the Mises Institute, is an economics graduate student at New York University. See his Mises.org Archive or send him MAIL.


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