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Saturday, November 29, 2008

"The Road to Depression"

Brad DeLong says two big mistakes made the crisis worse:

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying..., above all, to avoid a deep depression.

They have also had three subsidiary objectives:

  • Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
  • Prevent the princes of Wall Street ... from profiting from the systemic risk that they created.
  • Ensure that homeowners and small investors do not absorb too much loss, for their only "crime" was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse... The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail...

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called "lemon socialism," creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

    Posted by on Saturday, November 29, 2008 at 10:44 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (34)

          

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