Bankrupt Economics

Unfortunately, we lack experience with stabilizing financial markets, and the issue has been at the fringes of economics. Mostly, markets should operate freely. When is intervention justified? How?

Of course, economists recognized that the Federal Reserve should act as a "lender of last resort" and that permitting two-fifths of banks to fail in the 1930s aggravated the Depression. But the creation in 1933 of deposit insurance (now up to $100,000) was thought to prevent most bank runs, and the "lender of last resort" role never anticipated a worldwide financial system that mediated credit not just through banks but also through hedge funds, private equity funds, investment banks and many other channels. In congressional testimony last week, Bernanke admitted the Fed has been "shocked" at how elastic the "lender of last resort" role has become.

The resulting intellectual vacuum has spawned political chaos. Unpleasant and untested ideas invite opposition. Paulson's plan to buy up to $700 billion of impaired securities is wildly unpopular. It may not work and raises many problems. If the government pays too little for the securities, financial failures may mount; if it pays too much, it may create windfall profits for some investors and losses for taxpayers. But Paulson's plan has better prospects for restoring confidence by removing suspect securities from balance sheets than suggested alternatives would. Selective injections of capital into banks, for instance, might involve favoritism and operate too slowly to improve confidence. Psychology matters.

The economy will get worse. Mussa thinks unemployment (now 6.1 percent) could peak near 7 percent; other projections are higher. The harder question is whether financial turmoil heralds an era of instability. Our leaders are making up their responses from day to day because old ideas of how the economy works have failed them. These ideas were not necessarily wrong, but they're grievously inadequate at the moment.

© 2008