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Thursday, March 27, 2008

"Ten Days That Changed Capitalism"

I'm sort of surprised at the number of people coming to the conclusion that "something big just happened" that will change how capitalism operates. For example, Martin Wolf and David Wessel both conclude that recent financial instability overturns the idea that markets always function best when government involvement is minimized or absent altogether. They are talking about slightly different topics, Martin Wolf discusses how the regulatory environment must be changed so that financial markets will function better, whereas David Wessel is talking about active and direct government intervention to stabilize prices and markets. The first is about the end of "The Great Deregulation" and the second about the end of the belief that markets always quickly self-correct on their own, but in both cases the conclusion is the same, some markets must be managed using regulatory and/or stabilization tools in order to avoid problems that can negatively affect the entire economy:

Ten Days That Changed Capitalism, by David Wessel, Capital, WSJ (FREE): The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. ...[T]he government's recent actions don't (yet) register at FDR levels. ... But something big just happened. It happened without an explicit vote by Congress. And... billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. ...

Was this necessary? It's messy, uncomfortable and undoubtedly flawed in many details. Like firefighters rushing to a five-alarm fire, policy makers are making mistakes that will be apparent only in retrospect.

But, regardless of how we got here, the clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.

Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities. A wide gap means high mortgage rates, which hurt an already sickly housing market. ...

The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points. Money markets are still under stress, as banks and others hoard cash and super-safe short-term Treasurys.

Is it enough? Probably not. Although it's hard to know, the downward tug on the overall economy from falling house prices persists. The next step, if one proves necessary, is almost sure to require the explicit use of taxpayer money.

The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on.

In ordinary times, a capitalist economy lets prices -- such as those of homes, mortgage-backed securities and stocks -- fall to the point where the big-bucks crowd rushes in, hoping to make a killing. But if the big money remains on the sidelines, unpersuaded that a bottom is near, the wait for bargain hunters to take the plunge could be very long and very painful.

So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.

    Posted by on Thursday, March 27, 2008 at 03:42 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (32)


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