Tuesday, May 3, 2011

The Great Panic

In FED We Trust: Ben Bernanke's War on the Great PanicOver my Christmas break I decided to do some research on our nation’s financial system and the mess we are in. Specifically, I wanted someone credible and politically unattached (so Ron Paul was out on both counts). Upon visiting my local library and examining their selection, I settled on In Fed We Trust: Ben Bernanke's War on the Great Panic, by David Wessel, the editor of the Wall Street Journal.

It only took me four months to read the book (and no, it’s not that incredibly long, I just kept getting distracted). The book itself is well written and well researched, and gives some very helpful background history of the Fed allowing the reader to place certain actions in context. But while I had originally intended to do a deeper review, the billions and trillions got so jumbled up that I lost track sometimes of who was spending what. What I can write about, however, is the financial system in the broader scheme.

Reading Wessel the analogy of digging a hole came to mind. It has been said that, when you’re in a hole, the first thing to do is stop digging. This makes sense. However, if you’re in a leaking boat, you should not stop bailing water. Both the digging and the bailing involve the same motion, just with an opposite outcome. The problem with the financial panic is that it was sometimes hard to tell if we were in a boat or a hole. The inability to know that information led to a rather bumbling approach at times.

Fundamentally, though, Wessel—likely unintentionally—revealed a deeper truth: we have forgotten that the economy is made up of people. In A Humane Economy: The Social Framework of the Free Market, Wilhelm Ropke wrote:
“[A] whole generation of economists was so exclusively brought up as to operate with economic aggregates that it forgot the things which until then were the real content of economic theory and which should never be forgotten: namely, that the economic order is a system of moving, and moved, separate prices, wages, interests, and other magnitudes. . . . In the past, to be a good economist meant being able to assess the relationship between currently operative forces, and sound judgment, experience, and common sense counted for more than formal skill in handling methods illegitimately transferred from the natural to the social sciences; but the limelight became increasingly to be occupied by a type of economist who knew how to express hypothetical statements about functional relationships in mathematical formulas or curves.” (p. 193)
In short, what was lost from the equation was people; individual people making individual decisions to spend, save, or invest, which in the aggregate kept the economy running. For that is what keeps our capital based (or debt based) economy alive. As long as the banks and financial institutions have the trust of the public, they could continue to bet on their liabilities. But when that trust was lost, we saw the national equivalent of a run on the bank. Suddenly lenders wanted their money back, and when debtor institutions could not immediately come up with the necessary capital, they verged on bankruptcy.

To prevent these bankruptcies, the Fed took a number of steps, now collectively called the “bailout.” And, according to Wessel, they did work in preventing a bigger crisis from occurring. But lost in the process was the trust of the public. For although it is economically justifiable with charts and graphs to argue that the financial institutions were too big to fail, it does strike against common sense, especially since those institution’s executives were getting millions in bonuses during the very same time period.

For people, unlike numbers or chemicals, don’t always react the same way to the same conditions. Rather, doing everything “right” by the theory may not lead to the projected outcome. And the economists directing our economy should keep that at the forefront.
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