Uncertainty Causes Instability

Government tinkering creates uncertainty, which in turn causes market instability. We saw it in the 1930's and we see it today

Louis R. Woodhill explains how government's failure to maintain the dollar's value has contributed to our present financial panic:

Capitalism and the free market can only do their job if the government supplies constant, reliable units of measure. This is why Article I, Section 8 of the Constitution of the United States says: “The Congress shall have Power…To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”. The Framers seemed to understand that the dollar is a unit of measure, just like the foot, the pound, and the second.

In April, 2001, the price of gold was $255/oz. In March, 2008, it peaked at $1011/oz. The dollar, which is our unit of market value, had lost about 75% of its real value in seven years. (Today the gold price is around $950/oz.)

What does the free market do in the face of an unstable unit of measure? It tries to cope.

The classic way for a private entity to protect itself from inflation is to buy real assets with borrowed money. This is what drove the recent housing and commodities booms. For a long time, it made perfect economic sense to build houses (real assets) at a frantic pace and finance them with borrowed money. Between at least 2004 and 2007, anyone who didn’t borrow to buy real assets was a sucker—they were allowing themselves to be victimized by inflation while others profited from it.

Bill Frezza explains how capricious government standards fosters uncertainty, turning a recession into a depression:

Knowing the odds and payouts, as well as your own preference for a jackpot over pocket change, would you wager $5 on twenty-seven red at the roulette table? Enough people do to support a multi-billion dollar industry. OK, do you think anyone would play if the house was allowed to change the odds and payouts as well as any other rules of the game after each bet is placed?

That is the difference between risk and uncertainty.

Red and Blue tribal pundits agree that economic recovery can only occur if private capital returns to the market. That’s swell, at least they agree on something. So why is our brain trust in Washington doing every conceivable thing to maximize uncertainty, which only keeps us hiding in our caves hoarding gold?

Frezza has a point. Uncertainty is the reason why developing markets are starved for capital, forcing the third-world to entice investors with high returns: It is a dangerous place to invest. Capricious governments, crooked politicians and rotten legal systems chase capital to the stable markets of Europe, North America and developed parts of Asia.

Government policy schizophrenia has scared investors away. We're all sitting on our money because we don't know what will happen next. Frezza has a solution:

Do you want to get the country moving again instead of wallowing? Then consider this proposal, similar in spirit to the decision to declare a date-certain for our military withdrawal from Iraq.

Give us a date-certain when the Congressional circus and its media handmaidens will turn off the uncertainty machine so we can get back to work under whatever set of rules, subsidies, taxes, bailouts, and regulations they choose to saddle us with. Then freeze the plan and shut up.

http://www.realclearmarkets.com/articles/2009/03/sorry_but_capitalism_did_not_f.html
http://www.realclearmarkets.com/articles/2009/03/how_to_turn_a_recession_into_a.html