The Market Cannot Fix the Financial Crisis By Itself

The failure of the financial bailout proposal that was before Congress on Monday shows a profound lack of leadership by members of Congress.  In the biggest decisions of their lives, Congress chose to put party ideology ahead of the well-being of the American people.  In times like these we need elected officials who are prepared to lead a public that is nervous, frightened and angered by the events on Wall Street. 

Large chunks of Congress and nearly all of the financial pundits strongly believe in the financial markets and their ability to self-correct in the event of mass disruption.  As we have seen over the last two weeks, the cost of a self-correction by the financial markets is simply too great for our society given the financial interconnectedness of our institutions.  It should be clear to all that a significant government intervention is needed in order to prevent a severe recession.         

History has shown that the free market’s pricing mechanism works well under normal circumstances and we surely need to be careful when we decide to interfere with it. Adam Smith's invisible hand certainly corrects for many of the changes in the economy and the financial markets but given the complexities of our current era, until global asset values can be determined on a consistent basis, we must realize that there is simply not enough data on all of the credit products out there to allow for efficient financial markets.

One needs to understand that while people may believe that financial markets are infallible they have a profound tendency to seize up when a lack of information and data used to determine prices of financial assets does not exist, or is not accurate.  Financial Markets are simply not as efficient in this day and age as far-right economists would want you to think. 

Economics, like other sciences, has seen its practitioners strive to develop universal "laws" that can be applied to how the particular science functions in conjunction with the natural world.  In the case of economics, these laws have been used to predict how the economy will function.  While universal laws may work with Physics and its many equations, they do not work in a world where economic models and the “laws” developed by economists have a tendency to function only during a typical day in a financial market and not when financial markets are put under the pressures that we have seen over the last several weeks. 

To make the equations of economics work you have to make several assumptions such as that supply and demand curves are independent of each other and that both curves are independent of the market’s prices, the market perfectly prices in all available knowledge, people act rationally, all markets are perfectly competitive and prices are perfectly flexible.  None of these assumptions always stands up in the real world. 

In the real world, there is feedback between demand and supply curves, the market does not perfectly weigh all available knowledge, people act on their emotions and biases, no market is perfectly competitive and prices are not perfectly flexible.  In the last decade, we have had two bubbles burst, the dot-com bubble and now the housing/lending bubble.  Bubbles should never happen under a traditional economic theory that dictates ultra efficient financial markets. 

Let's look closer at the dot-com bubble to illustrate how traditional economic theories can break down.  Obviously, dot-com stocks were not priced rationally as their pricing was based on flawed group think that was focused on greed and the belief that anything was possible.  The high demand for dot-com stocks caused prices to skyrocket and as a response to high prices many more dot-coms were started and IPOed until the supply of dot-coms became so great as to pop the bubble sending prices back downwards.  As the prices of dot-com stocks rose, the demand for those stocks also rose as people wanted to get in on the profits.  The situation was similar with rising home prices as rising prices enticed many new players to speculate in the housing market.

If you examine the dot-com bubble you will notice that instead of the prices of dot-com stocks finding an equilibrium balance between supply and demand, prices instead shot up and then crashed down.  They did this because the demand for dot-com stocks was influenced by the flawed idea that the explosion of the Internet would lead to incredible dot-com company profits at some point in the near future.  This flawed idea sent dot-com stock prices shooting upwards and the idea spread, which was seemingly justified by the price action. 

As people saw dot-com stock prices skyrocketing they got in the game seeking the same profits that many people had made before them, this sent prices upwards further still.  Some people bet against the dot-com bull market, George Soros was one of them.  But George Soros and other dot-com shorters who called the top too early had their investments crushed and those that were long were rewarded with huge profits.  The market not only rewarded those that were long with profits but many used those profits to borrow on margin to purchase more dot-com stocks pushing the market up further.  The early shorts saw their capital shrink, making it more difficult for them to sell short driving prices back down.  In short, the process was self-reinforcing not self-correcting. 

Market bubbles self-reinforce on the upside as well as the downside.  The current housing bubble was caused by aggressive lending, a bias that housing prices never drop and an accelerating demand to own houses for speculative flipping.  Now we are seeing the other side of the bubble.  As the housing bubble reinforces on the downside we are seeing home prices drop which causes increasing foreclosures and erosion of the balance sheets of banks.  This makes the banks unable to lend to creditworthy businesses and individuals, as banks are unable to lend, home prices begin to drop further because people cannot obtain the credit they need to make purchases. 

Home price declines decrease both the demand to purchase houses and the supply of available credit.  As this process continues, the ability of banks to lend continues to decrease and this decrease in lending will eventually affect every area of the economy.  As the economy worsens, people will lose their jobs, further increasing foreclosures and further hurting the banking system.

The last time the market was allowed to correct a financial crisis (without timely government intervention) our country found itself digging out of the Great Depression. Fortunately, the Federal Reserve learned its lesson and we now provide liquidity to banks via the Federal Funds market and the discount window.  In addition, we attempt to deal with struggling banks that are deemed systemic risks.  In addition, we offer FDIC insurance on bank deposits and we attempt to intervene when the economy is contracting and banks are failing.  Members of Congress need to realize that the market interventions of the past offer a methodology by which the interventions of today can be carried out.

The real key as to why the financial markets cannot self-correct from the housing crisis is that prices are not downwardly flexible because of the role of leverage in our financial system.  A bank's assets can go down in price but its liabilities cannot.  Therefore, if its assets go down in price enough the bank can easily become insolvent and face certain failure. 

It is the same for homeowners because of their ties to depreciating assets.  When people are upside down on their houses they have an incentive to default.  As banks are unable to lend, due to a contraction in their balance sheet, the result is a decrease in the money supply, which is deflationary.  Should the price level of an economy decline, a business that has borrowed money to fund its operations will still be required to make the same payments regardless of any deflation in the economy and the effect of the deflationary environment on its business.

Essentially, what is occurring in today’s financial markets is that the self-reinforcing housing and credit collapse is beginning to raise the specter of deflation, creating yet another self-reinforcing process by which the economy will march ever so slowly to an unwanted fate.  Widespread deflation will crush the economy in a self-reinforcing manner because almost every business and individual with debt will experience financial stress. The more home prices drop the more insolvent banks we will have.  The more insolvent banks that we have, the less credit will be available, adding fuel to the deflationary fire and greatly impacting American business.

Either we can allow the self-reinforcing credit contraction process to continue and watch the economy collapse, or we can support our government’s efforts designed to recapitalize the banking system. It should be clear to lawmakers that this economy will not self-correct as many people think. Should congress fail to pass any meaningful legislation the Treasury Department and Federal Reserve will have to resort to buying what mortgages they can, printing hundreds of billions of dollars and offering full protection via the FDIC to bank depositors.

Comments

[Alex Filonov:]

Bravo! You just forgot to add that, like in Great Depression, prices for everything, not houses only, would go down, kicking off deflationary spiral. Welcome to Great Depression II!

2008 Oct 01 02:54 PM

[Andy Cole:]

Nothing our government does will prevent this recession from happening. Our society has been living on credit for the past ten years and now it's all coming back to haunt us.

2008 Oct 01 03:04 PM

[User 265729:]

Actually, this is a MARKET CORRECTION. You can call it whatever you'd like, but what will happen for the next 10 years is based on our excesses of the past 10-15. It all evens out in the wash. For those of you who are unfamiliar with basic economic theory, it is like what gravity is to physics.

Bloomberg, the Wall Street Journal, the New York Times, CNBC, ABC, NBC, CBS, PBS, Bush, Paulson...etc., etc. can all tell you that there is no gravity, but believe me, there is gravity. The only reason that we are hitting so hard, so fast, is that we've been held up with false lifelines so long, now that gravity (correction) has taken hold in the market, it will be like hitting a wall while driving 60 MPH.

The country has lived, especially during the past 10-15 years at the expense of a lot of economies in the world. Go visit Haiti, Liberia, even Mexico. Our status as a world power that can exploit other countries and their people at will is over. This is going to be a new game. A game where the biggest worry is not going to be getting Hanna Montana tickets for your kids.

2008 Oct 01 03:15 PM

[cyclingscholar:]

Typical left wing trash. You never define what a 'bubble' is, and no one else has either. I toss in 'bubbles' with 'climate change'...it can mean whatever ya want it to. It was the government that kept interest rates too low, forced mortgage lenders to give loans to incompetents, and looked the other way as Fannie/Freddie deteriorated.

2008 Oct 01 03:17 PM

[Smarty_Pants:]

Note to self: Don't let this guy invest any of my money for me.

"given the complexities of our current era, until global asset values can be determined on a consistent basis, we must realize that there is simply not enough data on all of the credit products out there to allow for efficient financial markets."

So the solution is to let the government figure out what the price should be when all those market participants with their education, experience, and expensive equipment can't?

Hahahahaha! Funny. I'm sure we'll wind up with the financial equivalent of the Post Office profit model.

Next.

2008 Oct 01 03:25 PM

[User 265729:]

Prudent, When you say...

*Obviously, dot-com stocks were not priced rationally as their pricing was based on flawed group think that was focused on greed and the belief that anything was possible.*

Isn't that what's being FORCED ON CONGRESS as we speak? A flawed GROUP THINK? We got into the Bay of Pigs, Vietnam and other messes through the same style of pressure that is being exerted on the House right now.

If this passes the House of Representatives we'll have an economic version of the Gulf of Tonkin Resolution.

2008 Oct 01 03:29 PM

[Pent up demand:]

"Congress chose to put party ideology ahead of the well-being of the American people."

You say ideology, I say principle. As others have stated, we are going to have a severe recession or depression; the butcher's bill will be paid. The question now is what will we have when we emerge on the other side? Corporatism/national socialism, or some chance at maintaining our freedom?

2008 Oct 01 03:59 PM

[punk_ash:]

Good article and interesting.

2008 Oct 01 04:18 PM

[James Kar:]

It seems the entire economy is put on hold because no lender is willing to provide financing of any kind, from home and car buying to small business investories. Of course, as I mentioned before, passing the bailout plan does not mean the banks will start lending. The banks do not want to lend because they afraid the debtors will default. Even they have money on hand, it doesn't mean they have to lend. This is an important but misunderstood situation: the banks actually have money but are not willing to lend. Remember, the Federal Reservce has been pumping money into the banking system. If the banks need money, they can always borrow from the Fed. The main issue is they afraid the economy will go into recession and there will be more defaults. A lot of people believing this is a liquidity problem, but it is not. This is an economic issue. As the global economy possibly go into recession, the banks have no reason to lend. The root of the crisis starts with decline in house prices. To fix the problem, we have to fix the root - get the house price to appreciate. How? By getting the economy going again. Homeowners would not walk away from their home if the houses worth more than the mortgage. People can start making payments when they have jobs. So, the ultimate solution is to fix the economy. I wonder what would happen if the Congress use the same $700 Billion to stimulate economy.

2008 Oct 01 04:54 PM

[MarvinMBA:]

Throwiing more money at a failed system will make things worst. There will be a new system of mortgage generation/funding that will not depend on a bailout. Save the taxpayer money and get M1 going again by providing cheap energy and tax reductions.

2008 Oct 01 07:01 PM

[MoroseMax:]

Flaws with the bailout:
- No plausible explanation of how it will actually improve things.
- Punishes those who lived within their means.
- Banks were never _forced_ to make these bad loans, they failed to exercise due diligence.
- The next crash will be in credit cards. Nothing in the plan addresses that.

The govt. should be making the same kind of deal that Buffett made with GE and GS.

2008 Oct 01 07:31 PM

[Nizzy:]

he did not mention credit cards because that is small compared to amount owed on housing and the impact of each.
THIS IS NOT SOMETHING WE CAN THROW MONEY AT AND IT WILL GO AWAY.
I do not belive their is anyway around a recesion, we may beable to stop it from turning into a depression yes. but not everyone understands what is going on at a time like this, for some they get the whole picture, other's it is too complicated for their mind's to concieve. but in order to fix it and assure future falls like the depression is to get awareness to the average person's and help them understand that they need to live within their means and the next generation's need tho know this so it does not happen again.

i dunno if you will get what i am saying i am young 21 y/o probably alot younger than most that care about these times.

Feb 02 01:16 AM