January 24th, 2008

What is the exact nature of the catastrophe?

It’s not a particularly radical statement to say that capitalism can be irrational. Keynes got it right back in 1936 when he examined short term behaviour in the stockmarket. And Greenspan knew what he was talking about when he warned of “irrational exuberance”.

One of the interesting aspects of the current financial crisis is that many of the problems are caused by an erosion of trust - banks won’t lend to each other and various markets have come to a halt because no one trusts other actors to have acted responsibly in disclosing how much they’re exposed to bundles of subprime debt. In many quarters, the finger is being pointed at regulatory authorities - because there’s no transparency in what’s going on. But that begs the question of whether immensely complex financial products are actually rational in the first place, or whether this result was always on the cards.

George Soros thinks the latter. Soros tends to cop it because he’s seen as some sort of class traitor - immensely wealthy but now prepared to warn of “market fundamentalism”. That seems to me unfair, and his own experience would suggest that he understands all this stuff better than most. It’s also interesting to read his view on the political economy of the current crisis, because the crazed nature of the way the American economy has been run - underpinned by the USD as reserve currency - is unsustainable, and we’re probably seeing the limits of that sustainability being reached now.

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.

This also begs another question - what can be done? Soros, in his Financial Times column, argues that what we’ve seen over recent decades is the creation of moral hazard through the intervention in collapsing bubbles by the state. Markets aren’t magically self-correcting, he suggests, and the irrationality which leads to crisis has been exacerbated by the willingness of regulators and government to step in and try to put things right when they go nuts. But he also thinks, for reasons which are quite cogently stated, that the limits of the effectiveness of Fed intervention are close to being reached. What all this suggests is that structural intervention is necessary, and should go beyond regulating for “transparency”.

Cross-posted at Larvatus Prodeo.

Tags: economics