Global markets are in a tailspin. The Nikkei fell 11%, the Hang Seng tumbled 7.1%, and the FTSE 100 declined 3%. Now the Dow is sinking like a stone in a deep pond. So, naturally, everyone is wondering what The Committee To Save The World will do next.
We’ve heard that a bailout of the bond insurers may be in the works. An emergency rate cut might be one the way as early as today. The Treasury Department and the Federal Reserve are gearing up for another weekend of meetings. But, really, what’s left to do? Do they have another bailout trick in the magic hat? Or will it just be another dead rabbit?
We won’t count out the possibility of some new program. The folks at Treasury and the Fed have demonstrated an amazing amount of creativity and flexibility in their attempts to ward off financial collapse.
But at some point, these strengths become a liability. Having the markets operate in fear of intervention risk makes it hard for investors and traders to formulate strategies. Do you buy a credit default swap to hedge against default risk or count on the government guaranteeing the loans? Should you invest in Morgan Stanley because it’s so beaten down or will the Treasury nationalize it? There are too many question marks at the end of every investment idea.
Maybe it’s time for the Committee To Save The World to take a bank holiday themselves. Because when you do everything your theory tells you to do but it doesn’t work, you should probably start to reconsider the theory.
We understand the theory of pre-emptive strikes against financial collapse. It makes sense to us. But shouldn’t we at least be a little more humble, a little less confident about the program. In the end, we’re gambling everything on a popular academic theory that’s only three or four decades old.
The theory, articulated most recently by Ben Bernanke, is built on a counter-factual. We know that monetary tightening, protectionism and allowing banks to collapse was followed by the Great Depression. So the academic theory holds that we should do things differently, respond with loose money and capital injections to prevent insolvencies. In short, if we do the opposite of what preceeded the Great Depression we think we can avoid another one.
This is all based on an unstated axiom according to which it is in our power to prevent a financial collapse. Now that axiom is being put to the test. We may well be learning that the world isn’t as cooperative as we thought. Perhaps after a long period of malinvestment, with massive amounts of capital allocated away from productive activities and into asset bubbles built around housing, we cannot avoid catastrophic economic consequences.
It’s not a pretty thought. But these aren’t pretty days.