In a recent post, Rafe quoted Frank Shostak as one of the dissenters who are critical of the bailout proposal, not only in its particulars, but in principle. Shostak sees all interventions of this kind as economically damaging as well as adding to the already existing mountain of moral hazard. His recommendation, in brief, is that markets be allowed to find their own way, however painful that path may appear in the short term.
My natural inclination is also to trust the market to sort out most problems. Indeed, had they been allowed to do so over recent decades, we wouldn’t be in this mess. As Shostak rightly says, it was a persistent unwillingness to suffer short term and necessary pain (in other words, to let creative destruction to do its job) that over time utterly distorted risk perceptions and so enabled things to reach such a state.
While I share his view that it would be preferable if both financial institutions and their customers were left free to act (and to bear all the consequences), I struggle to see how this will ever be the case in a social democracy. The political pressure to respond to pleas for help will always, I suspect, be just a bit too strong. At any rate, so long as that unwillingness persists, financial markets should remain fairly heavily regulated. They’re far too important to be given daddy’s credit card with which to conduct extravagant experiments.
Anyway, all of that is now history and can’t be unwritten.
Were Shostak’s advice followed, I think the US would soon be deep in depression. It may, indeed, be unavoidable even with the very best policies. The fundamentals that traditionally make such a calamity possible (extremely high gearing, heavily inflated asset prices, severe misallocation of capital and profound international imbalances) are all present, and supplemented, unfortunately, by a few new twists like the opaque and ubiquitous world of OTC derivatives. This toxic mix has been brewing for a long time.
The process of debt deflation that lies in wait once system wide leverage is high enough (and, Lord, knows, it’s never been anywhere near so high before) would sweep through the economy like a hurricane. Banks would disappear wholesale, lending would dry up almost entirely, the markets would be in complete disarray and firms would be falling like leaves from autumn trees. Oh, and asset prices would of course be in the tank.
Now, I think Frank (assuming he broadly agreed about the fundamentals) would point out that if all prices were free to adjust as credit is destroyed in such a debt deflation, then things might in fact work out moderately well after an absolutely traumatic 6-12 months. Assets and businesses would be priced at mouth watering levels and those who still had some capital could start rebuilding from a far sounder base.
And I’d agree with him, save for one thing. Prices would not be allowed to adjust, particularly not wages. More than anything else, this was, I think, what turned the 1929 crash into the Great Depression. All the attempts to hold up prices and wages were precisely the wrong thing to do. They should have been allowed to decline with the prices of assets, which of course fell along with the broader money supply in a reflexive process. Only then would the relative prices have enabled profitable, soundly based business to once again be done.
Without that flexibility, the US is faced with a different but equally unhappy dilemma. Do they allow things to take their course in the financial markets (as Shostak suggests) and perhaps have to endure levels of misery and unemployment that could match those of the Great Depression, lingering year after year as successive governments try all the usual nostrums but refuse to let the wider economy also adjust? Or do they try the Japanese route, keeping things apparently intact, socialising losses, trying to hold up prices, taking on vast new public debt and effectively appropriating private sector savings to spend on various make work schemes? Or will they hit upon, more likely, some uniquely American mixture of the two?
It’s by no means certain, in any case, that the US has the option of taking the Japanese route. When their hard times hit in 1990, they were a substantial net creditor and ran a decent trade surplus. Whether it was good policy or not, they could at least afford to finance their own bailout. No such luck for the US. It’s deep in the hole and has, as yet, shown no signs of finding a way out.
This is a very large problem, perhaps even a catastrophic one, and its origin, nature and eventual resolution will be debated and analysed for decades, perhaps centuries, to come. I agree with Shostak’s underlying argument about its causes and would dearly love to see these issues broadly debated. With greater understanding, the day might even come when we no longer need suffer such monstrous booms and busts (although I can’t say I’d put a bet on it).
In the meantime, though, I think the financial system does need to be helped down from its high perch. No one, in the years leading up to this crisis, was told to prepare themselves for a sauve qui peut world. To impose laissez faire rules now, out of the blue, would in my view be profoundly destabilising, not only for the markets, but more importantly, for the whole social fabric. In any case, since the markets wouldn’t be allowed to properly adjust to debt deflation any more than they were last time around, we’d still likely end up with a total mess.
I think the best we can hope for are least bad solutions, which will only grow out of holding a few principles in mind. Amongst them would be the recognition that: insolvency is the real problem, not illiquidity; asset prices should be allowed to fall to where they bear a sustainable relationship to their earning capacity; wherever possible, those who took the risks should bear the costs; the market is best equipped to set prices and manage assets unless in particular cases this becomes impossible; the conversion of debt to equity ought to be encouraged (and where necessary enforced) and, where the state has to take a direct stake, it should aim to establish an incentive structure that discourages opportunistic plundering of its resources while also providing it with some upside.
Finally, all the relative innocents who responded to the many official and other inducements to lever up and join in the American Dream should be helped to better survive the great unwinding. Not only, or even particularly, for reasons of fairness (which is in any case damnably difficult to determine) but to avoid a possible plunge into true social discord.
As for the vital discussion about why, and how, all this came to be (and how we can best avoid yet another repetition in a generation or two), one can only hope it will develop in parallel and that this bitter harvest may thereby bear at least some edible fruit.