Origins and Future of Crisis

By Christopher Lingle

ATLANTA ― A consensus has formed that the best remedy for the financial crisis is more government spending, more financial sector regulation and pushing interest rates ever lower.

It is strange that this view is taken seriously since none of the proponents of more government intervention in the economy anticipated the current turmoil.

This point is worth pondering. Policymakers and economists responsible for crafting a response to the end of the recent boom were clueless about the bust that has engulfed us.

Being unable to make sense out of obvious signs of impending problems indicates they are unqualified to pass judgment on cures. Instead of being discredited for lack of foresight, they successfully pinned blame for the havoc on greedy, incompetent bankers within unregulated financial markets.

Yet the single most important cause of the current economic and financial distress is loose monetary and credit policy.

As such, artificially low interest rates and cheapened credit were the fundamental causes of the financial crisis. If credit and risk had been priced correctly, it is almost certain that the housing and real estate bubble would not have happened.

By itself, loose monetary policy did not have to lead to the formation of the housing bubble. That mess required some more bad judgments that politicians and policymakers were only too happy to supply.

And so it was that regulations and legislation formed the proximate cause of the crisis by creating moral hazard, inducing bankers and homeowners to misbehave.

For example, implicit guarantees of federal support allowed Fannie Mae and Freddie Mac borrow vast sums of money that supported dubious investments that undermined the financial system.

Such low interest rates arising from the excessive liquidity created by central bank policies presented banks and borrowers with a once-in-a-lifetime opportunity. In a sense, they were victimized by the temptations to make a quick buck that led them to make what appear in hindsight as bad decisions.

And now central banks are trying to push market interest rates to the lowest possible level in response to financial market turmoil, declining output and a weak labor market.

As stated above, these problems can be traced to earlier actions by central banks to manipulate interest rates by relentlessly increasing bank circulation credit and the money supply.

Cutting interest rates and boosting liquidity interferes with the necessary workouts of bad debt and capital misallocation caused by earlier rounds of ill-advised investments.

Fed policies and government programs that prevent market-driven moves toward rational pricing of houses and other assets will extend and intensify distortions in the economy.

With the prices of many homes still inflated, supply and demand cannot be brought to equilibrium due to public interference with downward price adjustments.

As it was, propping up prices and wages during the 1930s met with disastrous results that perpetuated the Great Depression in the U.S.

After more than a decade of holding back market adjustments, the economy recovered within less than a year once a sufficient number of liquidations were allowed to occur.

As during the recent bubble years, inflating the money supply may initially stimulate production, but it eventually leads to less economic activity by punishing thrift. And it tends to undermine moral and intellectual values while allowing a relatively small group of people to accumulate massive amounts of wealth.

Indeed, outsized incomes of executives of multinational corporations and Wall Street bankers and brokers are also symptomatic of an inflated money supply.

Most central banks are following the same policies that set the stage for the bust, i.e., artificially-low interest rates with increased amounts of money and low-priced credit. These steps may postpone an inevitable downturn.

But by perpetuating and extending unsupportable investments undertaken during the bubble years, the costs of the ongoing bust will be higher and it will endure longer.

Preventing corrections of distortions in the production structure caused by artificially cheap credit also encourages a new round of distortions in the production structure.

As such, issuing more credit and money at unsustainably low interest rates is a cause of future problems and should not be to be a remedy for economic malaise.

As it is, the path of increased government spending and interventions in the economy will hinder the necessary market adjustments that might have brought a speedier recovery.

Consequently, the ongoing economic and financial turmoil is likely to linger far longer than it would if asset prices and wages could trend downward, sooner rather than later.

As a general rule, the stabilization policies being pursued at present by governments around the world tend to promote economic chaos rather than lead to stability.

As it is, politically-motivated policies to help entrenched interests fend off market forces that would bring economic change and dynamism are the main source of instability.

Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. He can be reached at CLingle@ufm.edu.