The world is not going to end.
This blog has a couple of financial-crisis-pessimists (JC & pommy), so I want to give the other side of the story. I accept that we are facing a financial crisis which is decreasing the access to credit and liquidity. I accept that this will lead to a drop in the share market and a recession. However, I believe that (1) this isn’t such a bad thing; and (2) we’re not facing a “great depression” scenario.
When I say it’s not such a bad thing, I don’t mean that recessions are good. However, in some situations they are inevitable. Austrian economists have been warning for many years that the American monetary policy has been too loose and that this would lead to a recession. I believe they were correct.
Austrian business cycle theory suggests that loose monetary policy (interest rate that are too low) leads to mal-investment because the extra money impacts on different parts of the economy at different times and in different ways. This monetary distortion will lead to over-investment in some areas. When prices adjust (which they eventually do) there will be a necessary unwinding of the over-investment… including drops in some asset values and some businesses going bust.
The best thing for the long term health of the economy is to allow this adjustment mechanism to take place. If the government prevents the adjustment, then the mal-investment will increase and we will simply face a bigger problem further down the road. Basically, given their previous decisions, America needs a small recession.
As a side note, I don’t believe that loose monetary policy is the only cause of the current problems. There was also a systematic miscalculation about risk. This was caused by bad regulation, moral hazard caused by implicit government guarantees (especially with Freddie & Fannie) and business mistakes made by people in the financial markets. It is important to admit that there were mistakes made in in the market. Economic liberals do not claim the market is perfect, and specifically with the functioning of the Credit Default Swap (CDS) market we have seen mistakes. This does not mean “the end of capitalism”. The market allows people to make mistakes, but it also provides the best mechanism for resolving the consequent problems.
Further, I don’t think Australia is facing the same problems as I believe our monetary policy has been relatively good, and we have different regulations.
The second part of my “case for optimism” is that we’re not facing a great depression. In 1929, when America (and the world) faced a financial crisis with reduced credit and liquidity, the federal reserve responded by decreasing the money base. As Milton Friedman subsequently explained, that is the exact wrong response. We will not see the same mistake now, insh’allah.
Risk assessments are being revised up, as is appropriate. In the short term we are seeing a dramatic over-estimate of risk, which is creating the credit/liquidity squeeze. The current risk premiums are not sustainable and will not be sustained. It will not take long before money starts to flow to safe businesses. Marginal businesses will certainly face problems, and some businesses will close or shrink (especially in the financial industry). But other businesses will continue to make profits, and they will continue to attract investment. When people see that the sky hasn’t fallen they will calm down and the risk premium will come down.
Given my relative optimism regarding current events, I do not support the US$700b bail-out being debated in America.
Besides concerns about the cost to taxpayers, my main problem with the bail-out is that it saves financial institutions from the consequences of their own mistakes. The idea of the market is that if you make better decisions you get a better outcome and if you make bad decisions you get a bad outcome. The bail-out provides a decision matrix of “heads I win, tails you lose”, which does not lead to optimal decisions.
I think it is important for the long-term health of the American economy that some businesses are allowed fail. Doing otherwise is the financial equivalent of “protectionism”, with (I believe) ultimately the same consequences.
There is also a disturbing double-standard at play, where lower or middle class people are not protected from the consequences of their business mistakes, but high-paid Wall street bankers are saved.
Instead of the bail-out we need to see two things. In the short-term the federal reserve needs to increase the supply of base money to offset against the reduction in the credit multiplier and the hoarding. At the moment we are effectively seeing a reduction in “broad money”. It is the role of the federal reserve to keep money stable, which requires “broad money” to grow at a low and stable level. The federal reserve need to not only add liquidity to the market, but also add actual money to the market (which can be done in a number of ways). This needs to be a short-term policy and monetary monetary policy will need to be tightened later to prevent excessive inflation.
The second response is a long-term response looking at the nature of our monetary system and financial regulations. But that is a topic for another day.