Confidence Game

David Strom
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Posted: Oct 01, 2008 2:30 PM
Confidence Game

Are we facing the worst financial crisis since the Great Depression? If so, why?

The simple answer is “probably.” And we are facing that crisis in no small measure due to the actions that are taking place in Washington D.C. and not in the financial centers of New York.

The credit crisis of today has been brewing for a long time; more than a year ago you could read about the “credit crunch” hitting markets and businesses and of you need to go back years to find the root causes for the housing bubble.

But the problems of even a year ago did not have to become the crisis of today. Wall Street has weathered serious problems in the past without massive government intervention and without causing journalists and politicians to begin reminiscing about the 1930’s. What turned this particular problem into a financial disaster were the remarkably maladroit actions of policymakers in Washington D.C.

First, let’s acknowledge that imbalances in the market are at the root of the current troubles. There is no doubt that a housing and lending bubble formed, and that the popping of that bubble has helped lead us to where we are today. Others have shown how lending rules set by politicians and monetary policies set by the Fed helped distorted the market for housing, but even without those prods this or another asset bubble could easily have formed. Markets are not infallible.

The popping of bubbles are invariably painful, and it is no surprise that policymakers jumped in to avert as much of that pain as possible. In doing so they unwittingly helped transform the credit crunch into the current credit crisis.

Ironically, Washington’s initial attempts to stem the bleeding transformed the painful but necessary correction into today’s market rout. As in 1929 and the early 1930’s, it was government intervention into the workings of the market that turned a serious problem into a crisis.

In the 1930’s the government helped create the Great Depression by making a number of blunders that helped destroy the underlying financial system. In particular the Federal Reserve stood by as bank failures led to a massive contraction of the money supply, drying up credit and leading to massive deflation that destroyed the American economy. This time around nobody can accuse the Fed of being stingy with money.

So what did Washington do this time that was so damaging?

From early this year the Fed and Treasury seem to have been following what I would call a “reverse Goldilocks” strategy, doing both too much and too little and getting the policy just wrong.

It’s hard to date when exactly the financial crunch transformed into a full-fledged crisis, but a convenient starting point would be the bailout of Fannie Mae and Freddie Mac. It was at that point that it became abundantly clear that any chance of simply muddling through the credit crunch was not going to be possible. If the companies holding nearly 70% of America’s mortgages were on the verge of bankruptcy then just about any company might follow.

The Lehman Brothers bankruptcy followed closely the demise of Fannie and Freddie, and the AIG bailout came just a day after the government let Lehman fail.

Two things were made abundantly clear by this pattern of events: first, in the judgment of the Fed and Treasury our financial system was on the brink of collapse; and second, they had no plan for how to deal with the impending disaster. They were shooting from the hip, and that’s not a great way to aim.

It was signals sent by Washington that destroyed the underlying confidence that is the bedrock of any financial system. Investors, rationally viewing Washington’s actions, quickly rushed to the sidelines in order to wait and see what the government was going to do in order to clean up the mess.

Obviously it was going to do something—the bailout of Fannie, Freddie, and AIG all signaled that some action was imminent. The bankruptcy of Lehman ensured that nobody could guess what that something might be. The failure of Lehman was intended to signal that whatever was done, it would be limited. It’s pretty hard to make rational decisions when you have no idea what tomorrow’s market conditions might be.

If Washington was going to act—and it was telling everyone it would—is it too much to ask that it have a plan before doing so? The unpredictable nature of Washington’s words and actions helped create the crisis atmosphere that is hurting our economy today.

Washington has done nothing to calm the rattled nerves of investors since. In fact, it has made things much worse. Almost every single action and statement coming from Washington has added to both the uncertainty and anxiety that investors are feeling right now. What was a problem last year is a crisis today.

By pushing the panic button when they had no plan to deal with the crisis, the “wise men” in Washington have made things unimaginably worse than if they had done nothing at all. It may or may not in fact be the case that there was no palatable path out of this mess without massive government intervention—a proposition that splits respectable economists, even free market ones—but it is certainly clear that having the most senior economic and political officials in Washington screaming that the sky is falling has been a sure path to creating, not tamping down, a sense of crisis.

Unfortunately the die is almost certainly cast. Now that the crisis is upon us it is almost impossible to conceive of a path out without massive government intervention. The whole world is waiting to see what Washington does, and until it acts in some decisive fashion markets will be in turmoil.

Washington now needs to buttress the confidence in our financial system that it has helped undermine. We can only hope that the policies they choose prove a lot more successful than the ones chosen in the 1930s.