Perhaps the best way to view a financial crisis is to look at it as a collapse in the risk tolerance of investors in private financial markets. Maybe the collapse stems from lousy internal controls in financial firms that, swaddled by implicit government guarantees, lavish their employees with enormous rewards for risky behavior. Or perhaps a long run of good fortune has left the financial market dominated by cockeyed optimists, who have finally figured that out. Or perhaps it stems simply from unreasoning panic.I agree with DeLong that the government has to prop these suckers up. But what the government can undo is 40 years of right wing propaganda telling us that the overlords of finance are the real smart people (think 'greed is good' by the character Gordon Gekko in the film Wall Street). The government can stop the brainwashing of the past 40 years and support critical thinking about 'finance capital' versus an economy built on producing real goods for real needs with good jobs that pay well. Not the froth of billion dollar bonuses for the 'overlords of finance'.
Whatever the cause, when the risk tolerance of the market crashes, so do prices of risky financial assets. Everybody knows that there are immense unrealized losses in financial assets, but no one is sure that they know where those losses are. To buy – or even to hold – risky assets in such a situation is a recipe for financial disaster. So is buying or holding equity in firms that may be holding risky assets, regardless of how “safe” a firm’s stock was previously thought to be.
This crash in prices of risky financial assets would not overly concern the rest of us were it not for the havoc that it has wrought on the price system, which is sending a peculiar message to the real economy. The price system is saying: shut down risky production activities and don’t undertake any new activities that might be risky.
But there aren’t enough safe, secure, and sound enterprises to absorb all the workers laid off from risky enterprises. And if the decline in nominal wages signals that there is an excess supply of labor, matters only get worse. General deflation eliminates the capital of yet more financial intermediaries, and makes risky an even larger share of assets that had previously been regarded as safe.
Ever since 1825, central banks’ standard response in such situations – except during the Great Depression of the 1930’s – has been the same: raise and support the prices of risky financial assets, and prevent financial markets from sending a signal to the real economy to shut down risky enterprises and eschew risky investments.
This response is understandably controversial, because it rewards those who bet on risky assets, many of whom accepted risk with open eyes and bear some responsibility for causing the crisis. But an effective rescue cannot be done any other way. A policy that leaves owners of risky financial assets impoverished is a policy that shuts down dynamism in the real economy.
It is still true that the banking-sector policies that were undertaken were good – or at least better than doing nothing. But the certainty that matters would have been much worse under a hands-off approach to the financial sector, à la Republican Treasury Secretary Andrew Mellon in 1930-1931, is not concrete enough to alter public perceptions. What is concrete enough are soaring bankers’ bonuses and a real economy that continues to shed jobs.
Wednesday, December 30, 2009
The Way the World Works
Here's a good short analysis of why the government has to bail out the fat cats who cause the current recession/depression. This is a piece by Brad DeLong for Project Syndicate: