How To Cause Great Depressions

A Minneapolis Fed paper summarizes the lessons of recent financial debacles in an attempt to help us avoid another Great Depression.  The bottom line?  We’re not out of the woods.

Key points:

  • The government response to financial-system catastrophes is more important that what caused the collapse in the first place.
  • Seizing and breaking up insolvent banks while reprivatizing strong ones is expensive, but it works.  See Chile and Finland.
  • Nursing insolvent banks and unproductive firms along leads to a Great Depression.  See Mexico and Japan.
  • We need to provide liquidity to our good banks, seize and dismantle our insolvent banks, and let companies like General Motors and Chrysler die.

Tim Geithner seems convinced that taking over banks is a terrible idea because governments do a bad job of running them. The flaw in this logic is that there is a big difference between temporary seizure and restructuring (Chile) and long-term ownership (Mexico).  As Japan has demonstrated, meanwhile, the third option–denying that banks are insolvent–doesn’t work, either.

Mexico and Chile

An instructive exercise is to compare the experiences of Chile and Mexico in the 1980s…  In 1981–82, both countries were hit by the shocks of rising world interest rates and falling international prices of the commodities that they exported — copper for Chile and petroleum for Mexico.  These shocks exposed weakness in the banking systems in both countries and produced financial crises.   
In 1982 in Chile, banks that held half of the deposits were suffering severe liquidity crises.  The
government took control of these banks.  Within three years, the Chilean government hadliquidated the insolvent banks and reprivatized the solvent banks.  The government set up a new
regulatory scheme to avoid mismanagement.  These new regulations allowed the market to
determine interest rates and the allocation of credit to firms.  The short-term costs of the crisis
and the reform in Chile were severe, and real GDP fell sharply in 1982 and 1983.  By 1984,
however, the Chilean economy started to grow, and Chile has been the fastest-growing country
in Latin America since then. 
In 1982 in Mexico, the government nationalized the entire banking system, and banks were only
reprivatized in the early 1990s.  Throughout the 1980s, in an effort to maintain employment and investment, the government-controlled banks provided credit at below-market interest rates to
some large firms and no credit to others.  Even the privatization of banks in the early 1990s and
the reforms following the 1995 crisis have not been effective in producing a banking system that
provides substantial credit at market interest rates to firms in Mexico.  The result has been an
economic disaster for Mexico:  Between 1982 and 1995, Mexico experienced no economic
growth and has grown only modestly since then.



To emerge from the crisis as did Chile and Finland, and not become trapped in stagnation
as did Mexico and Japan, we need to avoid implementing policies that stifle productivity by
providing bad incentives to the private sector.  With banks and other financial institutions in
crisis, the government needs to focus on providing liquidity so that banks can provide credit at
market interest rates, and using the market mechanism, to productive firms. [We are doing this.] Unproductive firms need to die. [We are not doing this.]  This is as true for the automobile industry as it is for the banking system.  Bailouts and other financial efforts to keep unproductive firms in operation depress productivity.  These firms absorb labour and capital that are better used by productive firms.  The market makes better decisions than does the government on which firms should survive and which should die…

Governments are now spending huge sums of public money to bail out financial institutions that had not been previously regulated.  Even aside from the costs of generating the need for more taxes, these bailouts will create difficulties for the future.  Risky investments will pay returns in spite of bad outcomes.  labour and capital will stay employed in unproductive uses.  Incentives for future investment will be distorted by moral hazard problems.  We got into the financial crisis that we are in now because of poor assessments of risk.  Indiscriminate bailouts in the financial sector will reward many of those who made bad decisions and make it even more difficult to assess risks in the future.  Understanding the moral hazard problems created by bailouts, many citizens and politicians will call for massive regulation of all financial institutions.  Directly and indirectly, massive and indiscriminate bailouts of the financial system will create inefficiency and low productivity.
What do we need to do now?  The central banks in the countries that are in crisis should lend to
banks to maintain liquidity.  Any bailouts of nonbank financial institutions should be
accompanied, at least temporarily, by strict regulations.  The bailout should not be used to maintain high returns either to the equity holders or to the bond holders in these institutions. 
Investors who made risky investments should not be rewarded when these investments have
gone bad.  Any public spending on investment in infrastructure should be justified on its own
merits, especially in terms of its potential for increasing productivity.  Otherwise, we should let
the market work in letting unproductive firms go bankrupt and reallocating what remains of their
resources to more productive firms.  Reforming bankruptcy laws in some countries could make
this process more efficient.
The people and the governments of some countries may decide that there should be some sort of
social insurance for workers who lose their jobs, for households who lose their homes, and even
for firms in some sectors or regions.  If so, this insurance should be provided directly and not
indirectly through massive and indiscriminate bailouts of firms.

Full Report

Study On How To Creat Great Depressions

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