When Governments Go Wrong (and Cause Depressions)

Good new paper out on how governments can cause depressions through ill-thought policy. Lots of historical frisson, especially given the current TARP 2 / stimulus rancor, so I'll just turn to the paragraphs on the ongoing crisis:

The fall in housing prices has exposed an even more fundamental problem in the financial system. Some investors and policy makers have come to regard some financial institutions, and even some manufacturing firms, as being too big to fail. In the banking system, a tension exists between the government insuring depositors in banks and in regulating the banks. The fundamental principle involved in efficiently allocating risk is that any insurance should be accompanied by regulation. Any institution that is too big to fail needs to be regulated.

Governments are now spending huge sums of public money to bail out financial institutions that had not been previously regulated. Even aside from the costs of generating the need for more taxes, these bailouts will create difficulties for the future. Risky investments will pay returns in spite of bad outcomes. Labor and capital will stay employed in unproductive uses. Incentives for future investment will be distorted by moral hazard problems. We got into the financial crisis that we are in now because of poor assessments of risk. Indiscriminate bailouts in the financial sector will reward many of those who made bad decisions and make it even more difficult to assess risks in the future. Understanding the moral hazard problems created by bailouts, many citizens and politicians will call for massive regulation of all financial institutions. Directly and indirectly, massive and indiscriminate bailouts of the financial system will create inefficiency and low productivity.

What do we need to do now? The central banks in the countries that are in crisis should lend to banks to maintain liquidity. Any bailouts of nonbank financial institutions should be accompanied, at least temporarily, by strict regulations. The bailout should not be used to maintain high returns either to the equity holders or to the bond holders in these institutions. Investors who made risky investments should not be rewarded when these investments have gone bad. Any public spending on investment in infrastructure should be justified on its own merits, especially in terms of its potential for increasing productivity. Otherwise, we should let the market work in letting unproductive firms go bankrupt and reallocating what remains of their resources to more productive firms. Reforming bankruptcy laws in some countries could make this process more efficient.

And it closes with this appropriately cautionary reversal:

Those who try to justify the sorts of Keynesian policies implemented by the Mexican government in the 1980s and the Japanese government in the 1990s often quote Keynes’s dictum from A Tract on Monetary Reform: “The long run is a misleading guide to current affairs. In the long run we are all dead.” Studying past great depressions turns this dictum on its head: “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

More here.

Comments

[JohnL]

Thanks for the link to the FRB report. Here is my favorite quote from the paper:

"Unproductive firms need to die. This is as true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity. These firms absorb labor and capital that are better used by productive firms. The market makes better decisions than does the government on which firms should survive and which should die."

This concept seems to elude the politicians.

2009 Feb 10 01:18 PM

[MarvinMBA]

I personally think there is no way our of our problems with any stimulus baleout or government spending plans for job creation. Just a minor blip on our downward spiral...how this is going to work out is anybodies guess, but I think if I were a farmer I would be relatively calm...MarvinMBA

2009 Feb 10 01:20 PM

[Alex Filonov]

I don't know if anybody can learn from Great Depression. And if anybody would from current Great Depression 2.0. The problem is: if you don't save banking system, you are going to ruin a lot of people, most of them not guilty in any financial mismanagement. You think you can make people more responsible? Sure, GD makes people more responsible. But GD repeats after 80 years, people made responsible by first one are mostly dead and people made responsible by current one will be dead by the time next one hits. Do you really think our grandchildren will believe anything we teach them? And if they do, they are total failures anyway.

2009 Feb 10 01:28 PM

[John Lounsbury]

I have been doing quite a bit of reading about The Great Depression (history) lately. It appears that one of the two major mistakes made in the Roosevelt years was the attempt to artificially support some wages and some prices in 1937-38. This took what had been a three year recovery and (along with the other major mistake-raising taxes in 1937) pushed the economy right back into recession.

This is why talk of supporting house prices makes me shudder. Throughout our history, supporting or restricting prices or wages has been a very negative influence on the economy.

I know that housing prices was only mentioned in passing early in the quote, but I feel strongly that attempts to put an artificial floor under them would just delay the start of a recovery.

2009 Feb 10 10:59 PM

[Jim Hawthorne]

John Lounsbury raises a good point: price/wage props and/or controls have pretty well been shown to be very negative economic influences, as demonstrated by the experiences in both Canada and the UK.

While governments may cause depressions through ill-considered or badly timed policy (such as knee-jerk protectionism), they can also play a role in assuring that recessions spiral into depressions by simply doing nothing!

Speaking of the history of the Great Depression, J.K. Galbraith's 'The Great Crash: 1929 is a most informative and entertaining primer!

2009 Feb 11 10:37 AM

[PainfullyAware]

Civil Unrest may skew the markets this time around to a greater extent.

Two things that are recent that do not bode well:

H.R. 45 (Blair Holt's Firearm Licensing and Record of Sale Act of 2009) introduced the first day of this session of congress.
Two years after the passage of this bill (should it make it), ALL FIREARMS in a citizen's possession must be registered, not just those purchased after the bill passes, and this apparently applies to antique firearms as well. Knowing where they are is the first step to confiscation. There are other implications as well.

And

The Health Care Overlord and Plan INCLUDED IN THE STIMULUS PLAN.

Bloomberg Article:
Ruin Your Health With the Obama Stimulus Plan: Betsy McCaughey
www.bloomberg.com/apps...

From the article:

One new bureaucracy, the National Coordinator of Health Information Technology, will monitor treatments to make sure your doctor is doing what the federal government deems appropriate and cost effective. The goal is to reduce costs and “guide” your doctor’s decisions (442, 446). These provisions in the stimulus bill are virtually identical to what Daschle prescribed in his 2008 book, “Critical: What We Can Do About the Health-Care Crisis.” According to Daschle, doctors have to give up autonomy and “learn to operate less like solo practitioners.”



When the citizens become an accounting statistic they become expendable.

Things do not look so good for the Land of the "Free" and the home of the "Brave".

Those who do not look where they are headed usually suffer painful injury. Safety is a function of awareness.

2009 Feb 11 12:35 PM

[pearl2k]

A simple and wonderful point. Price supports in the housing market will only delay a necessary and fundamental correction: home values to income levels.

On Feb 10 10:59 PM John Lounsbury wrote:

> I have been doing quite a bit of reading about The Great Depression
> (history) lately. It appears that one of the two major mistakes
> made in the Roosevelt years was the attempt to artificially support
> some wages and some prices in 1937-38. This took what had been a
> three year recovery and (along with the other major mistake-raising
> taxes in 1937) pushed the economy right back into recession.
>
> This is why talk of supporting house prices makes me shudder. Throughout
> our history, supporting or restricting prices or wages has been a
> very negative influence on the economy.
>
> I know that housing prices was only mentioned in passing early in
> the quote, but I feel strongly that attempts to put an artificial
> floor under them would just delay the start of a recovery.

2009 Feb 11 01:27 PM

[fireball]

well it looks like the cure this time may be the same as the great d.. russia is stepping up missle production to supply their muslim allies. china is arming with mega-bucks and we say "cccaaannntt'ttt wwewewweewe aaalllll jujusstst ggeget aalooong" all the fdr meddling just prolonged and deepened the pain so now we try it on steroids. ww2 ended the g.d.. ww3 may end this one. talk about rebuilding infrastructure and cutting down on the unemployment numbers. appeasement never works. socialism does not work.

2009 Feb 11 04:32 PM