Where’s Bastiat?

October 2, 2008

Ordinary people just don’t understand this financial crisis! Or so says Justin Wolfers over at Freakonomics. I agree with Wolfers that economists are to blame for this, though not with his absurd position that people oppose the bailout because they just don’t understand how credit helps the economy. Trust me, Mr. Wolfers, I understand: Credit is good.

What people really don’t understand is what will happen if the current financial institutions fail. And by people, I mean “economists.” Up to this point, these institutions have acted as the main link between those who save and those who use capital. Different producers are willing to offer savers different interest rates, depending on how well they believe they can use these savings. The differential interest rates offered to savers for different investments act as a signal to investors, telling them which uses of capital are relatively productive and which relatively unproductive. If I, as a user of capital, am offering a higher rate of return on your investment, it’s because I expect to use that capital to produce significantly more value in goods and services than I started with.

I’ve read a lot of opinion pieces on why the bailout is necessary, and not one has tried to explain what people would do with their savings if the current set of investment banks fail. The reason no one has tried to do this is because no one knows, because they haven’t taken the time to look for the grounding in the real world of what happens in the financial world. This is a big problem. Are we supposed to believe that the financial institutions created themselves out of nothing, that they are the uncaused cause? It’s not sufficient, in my mind, to say that we need to bail out these institutions because otherwise economists won’t understand what’s going on.

The economist to be emulating now is the French writer, Frederic Bastiat. Bastiat’s genius was in showing how economic well-being is fundamentally about satisfying consumers’ desires, nothing else.  In his essay “That Which is Seen, and That Which is Not Seen,” for instance, he destroys the claim that earthquakes and other natural disasters are good for the economy. When a broken window is replaced, some say, “at least now the glassmaker will have work, and strengthen the economy.” But the economic activity involved with that repair is what is seen; what is not seen is how that productive work could have been assigned in the absence of an earthquake or broken window. An activity that makes people no better off than they were before, like replacing a broken window, cannot be defended on that grounds that it is “good for the economy.” Keep this in mind, those of you who believe that World War II caused the end of the Great Depression.

The Candlemakers’ Petition continues to provide the most devastating argument against protectionism that I have ever read. Forget about linear regression analysis of cross-country data, case studies of the Brazilian copper industry, or even Ricardo’s simple theory of comparative advantage, and look at it from Bastiat’s perspective. The candlemakers in France face foreign competition which provides the world with their product at a cost far below what they can afford to sell for. By shutting out this foreign product and allowing only domestically-produced candles, the French government would support not only the candle industry, but also a host of other industries (rope makers, sheep farmers) who the candlemakers support to buy raw materials. The foreign competitor is the sun, which supplies light for free all day long. This essay focuses one’s mind on what is important in an economy: the consumer. Producers exist to meet the demands of consumers, not vice versa.

What we need today, in this financial crisis, is a new Bastiat. Not somebody who tells us what banks do. Trying to make a case for the protection of our current financial institutions without thinking about what would happen in their absence is like arguing for domestic candlemaking while ignoring the sun. What Fannie Mae and Freddie Mac do is What is Seen, and economists like it because they can understand it. What is Not Seen is what would be produced if banks hadn’t been sending this signal to savers saying “housing is the most important thing ever and we need more of it.” We should think about what we’re Not Seeing before we confidently predict disaster.

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