Sun, Jan 03, 2010 - Page 9 News List

Were the financial rescue measures worthy?

By J. Bradford deLong

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.

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 1930s — 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 close risky enterprises and stop 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.

The political problem can be finessed: As Don Kohn, a vice chairman of the Federal Reserve, recently observed, teaching a few thousand feckless financiers not to over-speculate is much less important than securing the jobs of millions of Americans and tens of millions around the globe. Financial rescue operations that benefit even the unworthy can be accepted if they are seen as benefiting all — even if the unworthy gain more than their share of the benefits.

What cannot be accepted are financial rescue operations that benefit the unworthy and cause losses to other important groups — like taxpayers and wage earners. And that, unfortunately, is the perception held by many nowadays, particularly in the US.

It is easy to see why.

When vice presidential candidate Jack Kemp attacked vice president Al Gore in 1996 for the Clinton administration’s decision to bail out Mexico’s feckless government during the 1994 to 1995 financial crisis, Gore responded that the US made US$1.5 billion on the deal.

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