Comments on: Optimism Quickly Fading

By: Richard

Richard — Fri, 19 Sep 2008 14:57:21 +0000

Thanks, Jason. The follow-on question, of course, is whether the perception of systemic risk with respect to new intermediaries/products was correct, and if so, what is the appropriate prophylactic government response, if any? If Federal guarantees lead to worse problems, then what is the right policy?

By: Jason

Jason — Fri, 19 Sep 2008 11:54:04 +0000

Richard, I believe it's 3. It was the implicit Federal backing of just about everything, and hey, that was a pretty good assumption. Why worry about risk when you know if you mess up badly enough, someone else is going to pick up the costs? Be careful though, you've got to screw up really badly if you want the bail out. If you're somewhat competent with risk, you'll have to eat the losses yourself.

By: Richard

Richard — Fri, 19 Sep 2008 10:28:42 +0000

We're suffering from a syllogism gone bad. Bear with me.

1. The main lesson Government learned from the Great Depression is that bank runs lead to credit contraction, deflation, and ultimately a depressed economy -- persisting for perhaps an entire decade!

2. To avoid bank runs, insure deposits. Deposit insurance is like mutually assured destruction where possessing nukes means never having to use them.

3. New financial intermediaries and products? Investment banks too big to fail without unacceptable systemic risk? Expand Federal insurance to cover counterparties to derivative contracts such as credit default swaps, and Fannie's and Freddie's mortgage portfolio.

4. Cut regulation of entities funding themselves from Federally insured sources -- all regulation is bad.

5. My God! Look at those Wall Street bonuses! Look at those leverage ratios! Belatedly discover that storied investment banks have been playing dice with other people's money and winning for half a decade or more, as long as real estate appreciated. And why shouldn't others permit it -- it's all Federally insured (at least implicitly under the too-big-to-fail principal).

6. Oops. Real estate prices are declining. Financial firms are bankrupt. Federal guarantees must actually be fulfilled.

Open question: where did policy go wrong in the syllogism? It led to catastrophe, but it is based on long-accepted "truths". My suspicion is that either the nature of systemic risk has been misunderstood, or that options other than Federal deposit/counterparty insurance have not been identified or examined. But there are other possibilities. Thoughts welcome.

By: Martin Brock

Martin Brock — Fri, 19 Sep 2008 10:17:41 +0000

A stable unit of account, i.e. stable prices, in all economic conditions would remove the need for risky corporate actions as well as naive regulatory solutions.

How do you propose to do that? Fixing the price of gold isn't the answer.

By: David Peterson

David Peterson — Fri, 19 Sep 2008 10:14:39 +0000

To be an optimist you can't get caught up in the day to day cyclical movement of things. You have to believe in the long term positive trend. While banning short-selling is without a doubt bad, how long can this ban last?

By: hanmeng

hanmeng — Fri, 19 Sep 2008 10:07:32 +0000

Frank Langfitt's report Do Federal Moves Take Us Back To The New Deal? quotes Boudreaux and Tyler Cowen as well but doesn't identify the "prominent economist" who "now refers to the U.S. as 'the United Socialist State Republic of America.' And [who] refers to Treasury Secretary Henry Paulson as 'comrade.'"

Of course NPR's conclusion is that government's role is to restore faith in the financial markets.

By: colson

colson — Fri, 19 Sep 2008 09:44:19 +0000

I was laughing over at SeekingAlpha when a so-called "respected analyst" was positing that they needed to bring back the uptick rule on short-selling. to which a couple of us pointed out that there's no "down-tick" rule on buying shares - so what was the point in the rule.

Btw Don, I heard you on NPR yesterday giving a quick blurb on the government intervention. Was it you who called it the United Socialist States of America? She didn't really connect it to you but she was talking about it before introducing your outtakes.

By: Ashish Kulkarni

Ashish Kulkarni — Fri, 19 Sep 2008 09:18:13 +0000

I'd disagree with that – labeling the ban on short selling is worse than annoying, it's infantile.
It is, unfortunately, something one would almost expect from government.
The only solace (if it can be called that), is that the malaise is worldwide –
http://blog.investraction.com/2008/08/pakistan-is-floored.html

By: Russ Wood

Russ Wood — Fri, 19 Sep 2008 09:13:59 +0000

Don,
I fear you are correct.
I think history shows that when government creates a mess, the electorate demands government attempt a solution. There have been many errors leading to this point, but the dominant one has been the wild instability in the value of the unit of account. Since the Fed has ignored this problem and political leaders have failed to hold them accountable, the elecorate now demands more socialism to soften the impact of this failure of "capitalism".
The instability of the dollar (inluding letting prices fall during growth periods)creates massive distortions in the economy. These distortions lead good businesses to take actions which turn out to look risky in hindsight after the landscape shifts. These distortions lead poliitions and bureaucrats to implement safeguards which turn out to have massive unintended consequences.
A stable unit of account, i.e. stable prices, in all economic conditions would remove the need for risky corporate actions as well as naive regulatory solutions.

By: Speedmaster

Speedmaster — Fri, 19 Sep 2008 08:18:36 +0000

Agreed on all points.

On short-selling, this was a recent piece I enjoyed.
http://mises.org/story/3066