I'm getting a fair number of emails asking "Why not let the thing collapse all at once instead of dragging it out? Wouldn't it be better to get it over with? Plus, no moral hazard!"
How do I say this? No. NO!. Excuse me, but the Austrian "work the rot out of the system" arguments make me a bit touchy.
The Great Depression is a good example of what happens when the government stands by while credit markets collapse. Oh, don't get me wrong, the government did plenty of affirmative bad things to prolong and deepen it, starting with Hoover's lunatic tax increase and defense of the gold standard, and moving steadily on to FDR's various insane attempts to rig prices, which only halted when some senators explained that no, they didn't really fancy giving the executive branch quasi-dictatorial powers, no matter how nice a chap FDR happened to be. But the credit contraction triggered by the stock market collapse is what got the ball rolling.
Financial markets are strange creatures. They are uniquely prone to turn negative expectations into self-fulfilling prophecies: if everyone thinks that your bank is going to collapse, it will, even if its financials are perfectly sound. When banks collapse and depositors lose all their money, not only do real people get hurt, but also the ripple effect does very, very unkind things to GDP.
Asking whether it wouldn't be better to get it all over with at once is like saying "I hate having to take my statins every day--why don't I just take all thirty pills this morning?"
For an explanation of how a lack of liquidity can crush the economy, you can't do better than Paul Krugman's old piece from 1998.
The market works!
Viva libertarianism!
Megan:
So you'll admit there is no such thing as "free" markets? Especially in the Kudlow sense.
Excellent point Megan, another thing people clamoring for collapse tend to rest on is that markets are somehow natural entities and we ought to let them do their work. Of course, none of this would be possible with out laws, regulations and protection of property in the first place. It's always seemed to make far more sense to assess each situation in particular and decide if intervention would be helpful or not instead of taking an absolute position on this sort of interventionism.
Also the Krugman piece has always been one of my favorites, thanks for posting the link.
"...This was, of course, gilt-plated flapdoodle. By my count, a year after graduation, about a third of my class was unemployed, underemployed, or waiting for some never-never job to start. The management consulting firm that I was supposed to work for strung us along just long enough to dump us on the market at the same time as the next class of MBAs. In the year that followed, I experienced something perilously close to utter despair..."--MM
your turn to spread the message?
"The Great Depression is a good example of what happens when the government stands by while credit markets collapse."
Really? Given all the caveats you follow that sentence with, you still think the Great Depression is a good example of a "do nothing" policy when credit markets collapsed? Seems like a terrible example to me. Sure, the stock market crash "got the ball rolling" in '29 without any gov't help, but the gov't clearly did not "stand by while the credit markets collapsed". They took plenty of actions, many of which you list, which only served to make that rolling ball of financial destruction a hell of a lot bigger and more destructive.
Also, the actions the government took following the '29 Crash don't offer a useful parallel to the Fed's action to bail out Bear Stearns today. Granted, the Fed allowed scores banks to fail after the '29 crash, but was it even possible for the Fed back then to have bailed them out? Would it really have helped to rescue those banks when a major reason so many failed was hyper-restrictive laws on interstate banking and investments that only increased the risk of bank failure? Would there have been as many bank failings without the horrendous economic policies pursued by Hoover and FDR?
Aside from that, I've found your arguments defending the Fed bail out of Bear Stearns to be surprisingly persuasive. I don't think the Great Depression comparison is helping you, though.
Financial markets are strange creatures.
Markets for financial derivatives are even more strange.
if everyone thinks that your bank is going to collapse, it will, even if its financials are perfectly sound.
Well, if they're fractional-reserve, yes.
A fully-backed bank can't collapse (because it will be solvent when 100% of reserves are withdrawn, which will restore confidence, no?), but admittedly isn't as useful for credit expansion.
Jonathan: Markets work best when the regulations and laws are a) strictly minimal to prevent fraud and the like, and enforce contracts
and more importantly b) don't change at the whim of the state.
When the State constantly re-evaluates the conditions and laws and changes them to achieve whatever immediate goal it has, that's an interventionist market, not a free one, and it loses efficiency for that very reason.
The State is much harder to predict and work into your pricing, if only because it can essentially do Whatever It Wants, unlike anyone actually in the market.
This is not a proof that interventionism is always bad, of course, but an argument against the idea that interventionism is likely to be "good".
That markets are not "natural" and depend on property and contract enforcement does not imply that more government "work" on them is likely to be helpful.
I think there's a fundamental risk in financial markets.
While there is a supply and demand like the market for goods, the concept of equilibium can be elusive, as we will now experience.
If you will allow me that disctinction, I have a good faith in markets, but worry that financial transactions dont really form markets in a dependable way.
Is it because pricing is conditional?
As I read the Krugman argument he confuses the real and nominal money supplies. In the babysitting example the two are more or less identical but not in the real world.
The Krugman article, for some reason, seems to exclude the possibility of markets adjusting prices. The baby-sitting scrip was fixed to equal one hour of baby-sitting.
If everyone wants to baby-sit, then maybe baby-sitting should just become really cheap. People trying to baby-sit during times when no one needs baby-sitting need to realize no one wants baby-sitting. Maybe someone wanting to baby-sit now for an hour can only get fifteen minutes back in the future. In a real market, prices can change without some sort of command-economy expedience of issuing new claims on real goods and services in the form of scrip.
If everyone wants cash instead of mortgage-backed securities (MBSs), maybe MBSs should just become really cheap and cash really expensive. Maybe firms who can't pay their bills or meet their contractual obligations on debt because they are holding stuff people don't want (MBSs, last season's handbags, expired milk) should be forced to sell something in voluntary exchange for what a willing buyer thinks it's worth. In a real market, prices can change without some sort of command-economy expedience of issuing new claims on real goods in the form of federal reserve notes.
I empathize with a desire "spread the pain," "cushion the fall," etc, but cheapening the medium of exchange used by everyone to make MBSs and their holders more palatable for the markets is bailing them out at someone else's expense. "Sharing the pain" is something each individual should be able to choose whether or not to do, not forced to do because they happen to hold US dollars.
The Krugman article amazes me. He somehow turns the perfect case study against government fixing prices into an argument for government intervening into the economy. He doesn't mention once in the entire article the idea of letting the price of baby sitting float.
The real question is whether prices are significantly sticky outside of government intervention. The burden of proof is on Meagan, Krugman, and other Neo-Keynesians to show this exists.
From the reading I have done, every single economic collapse has come from some variation of widespread maturity mismatching causing major liquidity crises. What we need is a sound money policy that prevents widespread maturity mismatching from happening.