Back to Basics By Alvaro Vargas Llosa

August 27, 2007

WASHINGTON—In 1993, the government of British Prime Minister John Major launched a campaign under a motto borrowed from the world of pop music—“Back to Basics.” As I watch the worldwide financial crisis triggered by the wave of mortgage defaults in the United States, I am reminded that at the heart of the problem is the departure on the part of the U.S. government and American consumers from basic economic principles.

Major’s campaign referred to moral rather than economic issues, but the association is still relevant. Considering the consequences suffered by many ordinary people, there is something immoral about having disregarded basic economic notions for quite some time.

In recent years, many people forgot that in order to consume and invest, one needs to save. This elementary truth was lost as millions of people responded to perverse government-generated incentives by living beyond their means. What we are seeing today is nothing less than the inevitable price of behaving irresponsibly.

As is often the case with a financial crisis, the original sin behind the current turmoil has to do with government policy. Since 2001, the Federal Reserve has kept interest rates absurdly low in order to prevent a recession. Between 2003 and 2004 the rate at which the Fed allowed banks to lend to each other overnight was 1 percent! This convinced people that there was abundant money for anyone who wanted it.

Easy money begets extravagance on the part of those who lend and on the part of those who borrow. So financial institutions came up with irresistible offers, including mortgages that required no down payment and adjustable-rate loans that charged low interest in the early years. Borrowers went wild, often taking out second mortgages or multiple consumer loans simply because they could.

The theory was that the days of saving were over. The “new economy” was supposed to rest on the creation of asset value as reflected, for instance, in the skyrocketing price of houses. In such a context, financial institutions came up with slick instruments by converting debt into securities. Those sophisticated instruments passed from one hand to another in a trading dynamic that was supposed to allocate risk efficiently. In fact, because the origin of these securities was in many cases bad debt, the whirlwind of security trading concealed the high risk involved.

Why should we save, many Americans thought, if foreigners are doing the saving for us? Government policy reinforced the economy’s irrational exuberance. Fiscal deficits didn’t matter, the authorities claimed, because there was plenty of foreign capital investing in U.S. assets. A short-term mentality drove many American consumers at the expense of long-term thrift—a mentality so resilient that even when the U.S. dollar started to depreciate, people continued to buy imports on a massive scale. Apparently, they were thinking that the price of their homes would continue to rise forever.

So here we are, in the midst of a financial crunch. I think the U.S. economy is so productive that the crisis will pass, thanks to an innovative segment of society that keeps inventing new ways of producing more with less.

But what is happening today is an indication that prosperity cannot be taken for granted. If those responsible for the current turmoil suffered the full consequences of their actions, perhaps the nation would get back to basics soon. Yet these sort of economic lessons are hard to come by because governments step in to bail the victims out. Even the European Central Bank, a supposedly inflexible monetary guardian, has thrown lots of money into the system, and Germany’s government has rescued IKB Deutsche Industriebank AG because of losses related to subprime mortgages—an illustration of how global this crisis has become.

Don’t get me wrong here. The explosion of sophisticated financial instruments has provided liquidity to many markets that would otherwise not exist, and private equity funds have boosted entrepreneurial activity in extraordinary ways. The spread of risk around the world through the international sale of debt instruments is also a very good thing. The problem is that those blessings can easily turn to tears when people lose sight of the basic principle that prosperity depends on the capacity to sustain investment and consumption in the long term—which in turn depends on the capacity to save for the future.

Charles V. Peña is Senior Fellow at the Independent Institute as well as a senior fellow with the Coalition for a Realistic Foreign Policy, senior fellow with the George Washington University Homeland Security Policy Institute, and an adviser on the Straus Military Reform Project.

William Ratliff is Adjunct Fellow at the Independent Institute, Research Fellow at Stanford University's Hoover Institution, and a frequent writer on Chinese and Cuban foreign policies.

Ivan Eland is Director of the Center on Peace & Liberty at The Independent Institute and Assistant Editor of The Independent Review. Dr. Eland is a graduate of Iowa State University and received an M.B.A. in applied economics and Ph.D. in national security policy from George Washington University. He has been Director of Defense Policy Studies at the Cato Institute, Principal Defense Analyst at the Congressional Budget Office, Evaluator-in-Charge (national security and intelligence) for the U.S. General Accounting Office, and Investigator for the House Foreign Affairs Committee. Full Biography and Recent Publications

Jonathan J. Bean is Research Fellow at the Independent Institute, Professor of History at Southern Illinois University, and editor of the forthcoming book, Race and Liberty: The Classical Liberal Tradition of Civil Rights.

Anthony Gregory is a Research Analyst at The Independent Institute. He earned his bachelor's degree in American history from the University of California at Berkeley and gave the undergraduate history commencement speech in 2003. In addition to his work with the Independent Institute, he regularly writes for numerous news and commentary web sites, including LewRockwell.com, Future of Freedom Foundation, and the Rational Review.
Full Biography and Recent Publications

Dominick T. Armentano is professor emeritus in economics at the University of Hartford (Connecticut) and a research fellow at The Independent Institute in Oakland, Calif. He is author of Antitrust & Monopoly (Independent Institute, 1998).

Alvaro Vargas Llosa is director of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. He is widely published and has lectured on world economic and political issues including at the Mont Pelerin Society, Naumann Foundation (Germany), FAES Foundation (Spain), Brazilian Institute of Business Studies, Fundación Libertad (Argentina), CEDICE Foundation (Venezuela), Florida International University, and the Ecuadorian Chamber of Commerce. He is the author of the Independent Institute books The Che Guevara Myth and Liberty for Latin America. Full biography and recent publications.

Pierre Lemieux is an economist and co-director of the Economics and Liberty Research Group at the Université du Québec en Outaouais and a Research Fellow at The Independent Institute in Oakland, California.

Alexander Tabarrok is research director at The Independent Institute, associate professor of economics at George Mason University, editor of the Independent Institute books, Entrepreneurial Economics, The Voluntary City (with D. Beito and P. Gordon), and Changing the Guard: Private Prisons and the Control of Crime.

Robert Higgs is Senior Fellow in Political Economy at The Independent Institute, author of Against Leviathan and Crisis and Leviathan, and editor of the scholarly quarterly journal, The Independent Review. Click here for a bio on Dr. Higgs, the noted economist and historian.

William Marina is Research Fellow at the Independent Institute in Oakland, Calif., and Professor Emeritus of History at Florida Atlantic University.

David T. Beito is a Research Fellow at The Independent Institute, Associate Professor of History at the University of Alabama, and co-editor of the book, The Voluntary City: Choice, Community and Civil Society.

William Marina and David T. Beito belong to "Liberty and Power," a group blog at the History News Network.

For further articles and studies, see the Center on Peace & Liberty and OnPower.org.

Nicolas Heidorn is a public policy intern at The Independent Institute in Oakland, California.

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