The housing crisis is in full swing; fifteen banks have failed; the top five investment houses have either closed their doors, found themselves under new management, or completely altered the nature of their operations; and the economy as a whole is almost certainly in recession. Much discussion has taken place as to how this crisis began; the question remains how best to return the economy to stable growth and how to prevent this kind of thing from happening again.

Those seeking a sudden resurgence are bound for disappointment. As Ben Bernanke has told us, “a broader economic recovery will not happen right away." The problem is that the past cannot be undone. Irrational markets making certain loans and financial instruments appear viable when, under normal conditions, they obviously were not, cannot be rebuilt, nor should they be. Losses on these investments will be absorbed by the economy regardless of whether they are borne by financial institutions or by taxpayers. That said, what can be done?

Actually, the appropriate course is not all that hard to identify. The precepts have been with us for millennia in the field of medicine and its about time that the powers that be heeded these principles with regard to the economy. Sadly, those powers have been notably unwilling to pay any attention.

The first principle is perhaps the best known in medicine: primum non nocere – “first do no harm”. This obvious directive was the first tossed out the door. The major players have not even been able to adhere to a basic precept of the Hippocratic Oath which states “I will neither give a deadly drug to anybody who asked for it, nor will I make a suggestion to this effect”.

Arguably these concepts were discarded as far back as 2001 when the Fed began administering the deadly drug of excess liquidity into the marketplace, but nothing can be done about that now. Instead, it is essential that the narcotics currently being administered be curtailed so that the economy can heal. Continued cutting of the Fed funds rate may seem like “the hair of the dog” but can only result in a prolonged period of withdrawal. Socializing still more economic losses can only increase the likelihood of inflation and remove still more resources from productive endeavors in the economy. And a governmental equity stake in our financial institutions may be the worst kind of economic arsenic. (Arsenic kills cumulatively and often gives the illusion of making the victim appear to improve before reaching its foregone conclusion.)

Calls for still more damaging “treatments” continue. Democratic members of Congress are vocally calling for another “economic stimulus (sic) package” despite the overwhelming evidence that such measures do not work and, instead, cause further harm. Similarly some have pushed for relief for those who cannot afford their current mortgages. Again, this merely shifts inevitable losses from those who made ill-advised decisions to taxpayers.

Efforts to “jumpstart the economy” are also ill advised. New taxes on “windfall profits” have never been anything but a drag on the economy. It must also be remembered that government spending has never created so much as a single net job – not one. It’s impossible. Even if the government were 99% as efficient as the private sector, the best that it could accomplish would be to create 99 new jobs at the cost of only 100, or the economic equivalent, as the resources used by government to create jobs must, by definition, be taken from the more efficient private sector. Of course, governments are far less efficient than that.

A popular misconception is that the problem is simply “government waste”. In defense of governmental intervention, it is frequently argued that less than two cents of every tax dollar are spent on bureaucratic waste (so sayeth Al Gore’s National Performance Review). The problem with that assessment, even if it is true, is that it has no relevance to the question of economic efficiency – the function of the marketplace to allocate resources to where they can be employed to the greatest benefit.

So what can government do to facilitate recovery? Simple: let the market work. This is not merely a case of doing no harm, but rather undoing the harm that has already been done. Certain obvious measures come immediately to mind:

Repeal Sarbanes-Oxley. Co-authored by perhaps the least competent Banking committee chairman in history (including Christopher Dodd), this legislation has cost the economy several times the amount of the economic losses associated with the events (Enron, Worldcom, etc.) that it was ostensibly designed to prevent. One study (Zhang 2005) indicated that the impact is as high as $1.4 trillion. Another, conducted annually by Finance Executives International (FEI) put the figure for 2007 alone at 0.036% of corporate revenues which seems like very little until one realizes that the vast majority of personal consumption flows through corporate revenues and that amounts to more than $9.7 trillion (2007 GDP component). If just half of that flowed through corporate revenues, the cost of Sabanes-Oxley in a single year was greater than $175 billion.

End subsidies/price floors. Whether they are to protect American sugar interests (at the cost of American candy makers) or steel jobs (at the cost of jobs in industries using finished steel) or to promote bio-fuels, no subsidy or price floor has ever done more good to the US economy than harm. Whole most such measures are not as harmful (or stupid) as those that actually pay farmers not to grow certain crops, they all harm American consumers and, ultimately, workers, because they reduce economic efficiencies and thus destroy jobs. The popular defense of such measures is that they protect “vital” interests or “promote” alternatives that create jobs. But the arguments are nonsensical. No one industry is more vital to the country than the prowess of the economy as a whole and any “alternative” that would create jobs would, by definition, have already attracted private investment in the absence of governmental interference.

Open up ANWR and the continental shelves to oil drilling. While the price of a barrel of oil has plummeted due to changes in aggregate demand, the underlying market principles behind developing domestic resources remain unchanged. The largely unwarranted environmental concerns about these measures are easily addressed while the development of these resources both attracts capital in the near term and benefits consumers in the long term. That oil is a finite resource and will eventually be supplanted by some alternative as the chief source of energy does not in any way undermine the reasoning behind developing the resources that exist. And, again, no governmental intervention will accelerate that change without harming the American consumer and worker.

On Friday, Federal Reserve Chairman Ben Bernanke “applauded” the passage of a $700 billion financial bailout because it was “a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses”. In addition, he promised that the Fed "will continue to work closely with the Treasury as it undertakes these new initiatives … [and] continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy." What he didn’t say was that the bailout will do nothing to address the underlying causes of the financial crisis and, instead, will likely make things worse because it grants ever more power to the one institution most responsible for the crisis in the first place – the very entity Bernanke runs.

That’s right campers, despite all the rhetoric to the contrary, the sudden contraction of credit, the real estate fiasco and the ripple effect that these items have had on both Wall Street and Main Street were not the result of corporate greed or excess deregulation or even, at least at the outset, the nature of mortgage lending. The initial cause of the crisis was none other than the irresponsible actions of the Federal Reserve Board. And despite the comments of our come-to-the-rescue Fed Chairman, there is absolutely no doubt that he knows it.

In looking for a cause of the monetary meltdown, much attention has been focused on the policies of the current administration, the disinterest of Barney Frank and Chris Dodd, the endless appetites of mortgage lenders, the irresponsibility of borrowers, etc., but, while there is plenty of blame to go around, ultimately all of these things are merely symptoms, rather than causes. The desire of lenders to initiate mortgages and borrowers to purchase homes is not new. The corruption or inattention or incompetence of public officials is not new. And none of the deregulatory actions undertaken in the last thirty years had anything whatsoever to do with the failure of so many mortgage-backed instruments. What, then, caused these pre-existing conditions to become a suddenly severe economic malady?

What, indeed. While political sound-bytes eagerly compare current conditions to the Great Depression, it is interesting to examine what similarities there are between the two events. Certainly, there is no comparing the severity of the two events. Of the more than 25,000 banks in business in 1929, fewer than 15,000 survived to 1933; unemployment rose to 25% in 1933 (and, after improving, spiked again to 19% in the wake of FDR’s policies); the economy shrank by more than a quarter in just four years – an economic disaster such as the world had never seen. A contraction of that magnitude is, by no means, contemplated now. Fewer banks are expected to fail than during the S&L crisis a couple decades back – also the result of government failure – and unemployment at 6.1% is still below historical norms. What is truly comparable about the current crisis and the Great Depression is the set of actions that triggered them.

As eminent economist Milton Friedman and co-author Anna Schwartz pointed out in their groundbreaking “A Monetary History of the United States 1867-1960”, the Great Depression was caused by a loose monetary policy in the years preceding the Depression - fueling the “roaring 20s” – followed by a sudden contraction of credit that caused a liquidity crisis. Matters were made abundantly worse by banking laws that made it nearly impossible for financial institutions to diversify and a further Fed contraction of credit at a time when banks were going under from lack of funds. Additional insight into these events can be found in James Powell’s “FDR’s Folly” and Murray Rothbard’s “America’s Great Depression”.

Fast forward to 2001. After more than a decade of steadily bringing down interest rates to the approximate historical cost of liquidity, the Fed went on a further spree. Between May and November of 2001, the central bank slashed the Fed funds rate from 4.0% to 2.0%. Not satisfied with that massive infusion of liquidity into the economy, the Fed slashed rates below 2.0% in December and didn’t raise them above that level for three full years.   Liquidity flooded the market faster than the Katrina surge flooded New Orleans.

This influx of cash had an effect on the marketplace that was nothing less than predictable. Low rates create incentives for lenders to lend and borrowers to borrow. That the rates were held artificially low by government fiat does not change the impact that such low rates have on the marketplace. The problem was made worse – by several orders of magnitude – by the actions of Fannie Mae and Freddie Mac, giving a false sense of security to all the actors in the marketplace by essentially endorsing riskier mortgage-backed securities that would not otherwise have been available in the first place. This imprimatur influenced not only borrowers and lenders, but rating agencies and industry analysts. The whole series of malinvestments and market distortions began with the over-abundance of liquidity induced by Fed mismanagement. But that’s only half the story.

Beginning in July 2004, the Fed reversed course and began raising rates. This long-overdue adjustment began to stem the tide of excess cash in the economy. The rate rose to 2.0% by the end of the year; six months passed and it was at 3.0%; another six months passed and it was at 4.0%. Still locked into the interventionist mindset that caused the problem in the first place, however, the Fed kept right on going. Within another six months, the rate had risen to 5.0% and eventually topped out at 5.25%. Where once the rate had been well below the market rate for liquidity, it had now swung too far in the other direction. This is what we call a “credit crisis”. Liquidity disappears, asset values tumble. The economy does not merely correct itself – which, again, was inevitable, it over-corrects.

And the cycle that once created the Great Depression, in this case exacerbated by mismanagement at Fannie Mae and Freddie Mac rather than the disastrous policies of the New deal, repeats itself. The liquidity boom and bust created by the Fed - all-too-frequently mischaracterized as a fundamental aspect of capitalism when nothing could be further from the truth – and so thoroughly described in that seminal work by Drs. Friedman and Schwartz, had once again thrown the economy into chaos.

Back in November of 2002, on the ninetieth birthday of Milton Friedman, Ben Bernanke stated, “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Promises, promises.