Schumpeter is, besides Smith and Mises, probably the most quoted economist among libertarians, even though few people have bothered to read his works. Libertarians, and Rove as well, often quote the notion of the destructive and innovative power of capitalism, bringing to the front new solutions and technologies. Schumpeter argues that innovation often comes from outside an established industry – and that should give readers a clue why Roves defense of the American Energy Policy is so mistaken.

Rove argues, blatantly with Schumpeters words, that the American Energy Companies should not be held responsible for investing in alternative energies because a) they know better than government b) they already invest in alternative energies c) the market produces the best energy mix incorporating both costs and possible profits.

Surely Schumpeter would have easily dismissed such a short-sighted argument. In modern terms, there are number of reasons why we would not necessarily expect the market to work perfectly. Oligopols reduce competition and allow excessive rent-seeking – something quite visible in most energy markets in the world. Regulatory capture prohibits internalizing potential risks and external costs into the decision-making process. Path dependence makes it difficult to switch a network technology from one alternative to the other.

None of these have to do with government interference – no, that’s not true. All of them have to do with government interference, but not necessarily with too much government interference.

Oligopolies in network technologies (energy, transport, communication) are difficult to break up, the European Union can sing plenty of songs about their efforts to break up the Energy-Quadropoly in Germany. Regulatory capture is particularly difficult if the administration, as under Karl Rove, is heavily tilted towards an industry and does not encourage regulators to intervene. Path dependence can only be reduced by subsidizing alternatives – heavily!

What the American Libertarians need to learn is that there is little hope for the market to magically bring about alternative energies. It needs an approach on several levels:

On the demand side, give incentives to consumers to use less energy, save energy or buy alternative energies. Government-supported renovation programs to make houses up-to-date with heat- and electricity-standards can help. Lower taxes on fuel-efficient cars are good incentives. These instruments do not prescribe a certain behaviour, but simply encourage another market framework.

On the supply-side, it helps to pay a higher reimbursement to providers of alternative energy, something which has been running successfully in Germany and has drastically increased the share from Wind- and Solar-Energy.

On the network-side, it is crucial to separate the various stages: from production to transport to distribution of energy. This can only be done by a tough regulatory agency.

It is difficult to acknowledge this, but libertarians who like the market, need to empower the goverment to create a market framework which works. This is in fact what Schumpeter was skeptic of, that a government could be too weak to harness the destructive force of the capitalism. Schumpeter actually argued that capitalism will eat itself because bureaucracies would be too weak.

Karl Rove seems to be unaware of that position of Schumpeter.

(This skepticism edges on the border of radicalism, for instance when he assaults the environmentalist movement and compares them to communism and nazism, without understanding the political economy governing global environmental regimes.)

In his article, he calls for a return to the Gold Standard. The standard argument against a return to the Gold Standard is that the volume of gold does not grow fast enough as the volume of money that is needed for the economy to grow. To fix that problem, Reisman proposes to set the price of Gold held at the reserve at about 12.700 US-Dollars and then assign this gold to the banks holding deposit accounts and other type of highly liquid assets.

Unfortunately, he does not discuss one prominent problem with the Gold Standards: most of the US-Dollar-Reserves are not held by commercial banks inside the USA, but by Central Banks outside the USA. Would the Fed really hand over their gold (even if it stays in their vault) to the Chinese Central Bank, for instance?

Reisman also discusses the vicious circles of highly-leveraged financial markets and how deflation can spread through an economic system. What is particular interesting are how the losses occured from loans in subprime mortgage market can have a more detrimental effect on the economy as whole (his full argument is present in the CMAP, click on the picture).

First, from bond-insurers to credit-rating-agencies to banks:

[B]anks’ capital now hinge[s] on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms [...] reduce the ratings of all the bond issues [...] deprived of insurance coverage. [...] [L]ower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. [If these] bonds were owned by banks, the value of the banks’ assets would be correspondingly reduced [...]

Secondly, from banks to prime-mortgage-lenders:

As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets.

Thirdly, from the prime-mortgage-lending market to government-sponsored lending market:

The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. [...] The Federal Reserve’s rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages.

Fourthly, from banks to the business needing credit:

The decline in the assets and capital of banks [...] reduce[s] the ability of banks to lend money to borrowers to whom they would otherwise normally lend. The effects of such credit contraction [...] be seen in the growing difficulty even of sound firms to obtain financing required for expansion.

Fifthly, from the banks credit contraction to a multiple credit contract because of minimum capital requirements:

[R]eductions in the capital of banks can result in multiple contractions of credit. [...] [B]anks are normally required to possess capital equal to five percent of their outstanding loans and investments. [...] [R]eductions in banks’ capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.

Sixthly, from multiple credit contraction to reduction of money supply

Credit contraction by banks [is 9reducing the outstanding volume of checking deposits in the economic system and [...] the quantity of money in the economic system. [...] If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears.

Seventhly, from money supply to business earnings to business spending to wages to private consumption:

Such contraction of credit and money operates to reduce the amount of spending in the economic system. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues. This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers’ goods.

Eightly, from decreased spending of businesses and consumers to banks:

As the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.

The message is clear: a small loss in a small share of the market can result in a contraction of the whole economy through various feedback loops.