Crisis of Confidence

Are we really in the midst of “one of history’s great financial crises”? That’s what Paul Krugman thinks:

I’m more concerned that despite the extraordinary scale of Mr. Bernanke’s action — to my knowledge, no advanced-country’s central bank has ever exposed itself to this much market risk — the Fed still won’t manage to get a grip on the economy. You see, $400 billion sounds like a lot, but it’s still small compared with the problem.

Indeed, early returns from the credit markets have been disappointing. Indicators of financial stress like the “TED spread” (don’t ask) are a little better than they were before the Fed’s announcement — but not much, and things have by no means returned to normal.

What if this initiative fails? I’m sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but there’s only so much the Fed — whose resources are limited, and whose mandate doesn’t extend to rescuing the whole financial system — can do when faced with what looks increasingly like one of history’s great financial crises.

The next steps will be up to the politicians.

Are we in the midst of a financial crisis? Or a crisis of confidence? Is there a difference? I’ve got to admit that the closing words of Dr. Krugman’s column, “The next steps will be up to the politicians”, are enough to shake my confidence.

Perhaps someone more knowledgeable than I can comment on this but the current problems look to me very much like the situation in Japan in the early to mid 90’s after their real estate bust. IIRC they reduced interest rates practically to zero without a great deal of effect. Then they announced a government spending plan to stimulate the economy but, with typical Japanese frugality, spent less than a third of what they’d appropriated. It finally took banking reforms to restore confidence and get their economy back on track again.

Unfortunately for us our economy is much more dependent on consumer spending than Japan’s has ever been.

Maybe we can skip the intervening steps and get straight to the regulatory reform. The next steps will be up to the politicians.

6 comments… add one
  • Dave,

    I’m not worried about the economy so much – I’m more worried in the “crisis of confidence” of which you speak. IOW, I’m worried that politically-motivated election rhetoric on the state of the economy will have a compounding negative effect on any real economic weakness. Perception being reality and all that. ISTM if consumers believe Mr. Krugman’s predictions, regardless of whether they are true or not, they will nevertheless become a self-fulfilling prophecy.

  • We’re in a wide-spread financial crisis. Currently the big central bankers are trying to shore up the system before anymore big banks go belly up. (So far there was the one that failed in Britain, and I believed they bailed another one out.) Apparently Bear Sterns is teetering on the brink right now, and while actions of the last week haven’t been specifically targeted to saving Bear Sterns, they are at least providing a prop for the moment.

    I’m too lazy to reproduce some of the stuff I typed up yesterday, but this crisis is real, and may well be the biggest financial crisis since the Great Depression. (Actually, that part seems certain.) The goal now is to keep the financial problems from creating too much chaos in the ‘real economy.’ I had commented on some of this yesterday (with links to show I wasn’t completely talking out of my hat) here. (See the last four coments under my nom de blog.)

  • The Krugman link points back to this post. (Here’s the correct link for anyone reading before Dave puts the fix in.) The Krugman piece is pretty good. I can’t stand reading his political stuff, but here he’s just functioning as an economist. This is a solid piece.

    If one wants to here the same basic message from another source, here’s an article covering a talk by National Bureau of Economic Research President Martin Feldstein. (Quoting from the article: “NBER is a private sector group that is considered the arbiter of U.S. business cycles. Feldstein is also a Harvard economics professor and former economic advisor to President Ronald Reagan.”) He’s veryt pessimistic:

    Answering questions from the audience, Feldstein said the downturn could be the worst in the United States since World War Two.

    Feldstein said the federal funds rate, the Federal Reserve’s benchmark lending rate, is headed down to 2 percent from the current 3 percent.

    He added that lower rates from the Fed would not have the same impact in the current downturn, in terms of reviving economic activity.

    “There isn’t much traction in monetary policy these days, I’m afraid, because of a lack of liquidity in the credit markets,” he said.

    One final point before I get back to work: There’s no regulatory fix for this mess, unlike the Japanese crisis. This has been caused simply by bad decision making over the space of many years by many people. When all is said and done Greenspan’s reputation is going to take an immense hit from this fiasco. (That’s not to say that there aren’t lots of other guilty parties.)

  • I don’t think that there’s solely a regulatory fix but I think that a regulatory fix is part of the complete package. As I’ve said before in previous posts, once you’ve stopped the bleeding it probably makes sense to see that the wound isn’t re-opened.

    That’s my main criticism of pouring money in to shore up failing institutions. While I understand that’s probably what will be necessary in the short run to prevent confidence from deteriorating even farther, as long as the incentives to make bad decisions are in place (and they are) and the consequences of bad decisions are nil, the decision-makers will go right on making bad decisions.

  • Dave, I just don’t see how you can regulate against stupidity.

  • I don’t think it’s stupidity. I think it’s cupidity. The incentives were very, very high, the oversight very low, the risks incorrectly perceived to be low. While I think that companies, whether publicly held or privately held have a right to pay their employees anything they care to, I also think that when compensation rises over a certain level it can’t be thought of as the legitimate cost of running a business any longer.

    Specifically, I think that financial services companies that pay bonuses based on single-year performance should be hauled onto the carpet. Bonuses should be based on life-of-the-loan, not on year-to-year sales.

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