While financial success and failure are entirely expected and normal for markets, systematic losses generally are not, at least, not without a common underlying cause. In this and a few subsequent Minutes, I will discuss some of the features of this complex series of developments.
“Black September, the biggest financial shock since the Great Depression, is prompting a Republican Treasury secretary and Federal Reserve chairman to devise the most muscular government intervention in the economy since the Great Depression in an effort to prevent the economic devastation of the Great Depression.”
The Federal government, the Federal Reserve and the U.S. Treasury have been debating just how broad the proposed new powers to regulate markets and the financial sector of the U.S. economy will be. The aim: to ‘fix’ markets in the short run as best as can be done, and to build in safeguards for the long run. An ideal solution would somehow work so as never to allow such deep, sudden financial upheavals to occur again. Regulatory arguments today are a replay in many ways of those that accompanied the chartering and creation of the Federal Reserve in 1913, a ‘never again’ determination regarding liquidity crises.
As is often the case when trying to dissect an economic problem, we need to decide where to fix our attention. We are making decisions right now and operating in the short run. The long run is our planning horizon—far enough off that anything may change by then. So we bridge the gap between the certainty of ‘now’ and the uncertainty of ‘eventually’ by attempting to meet short term goals that mesh with with our long term objectives. The better the match between our short-run actions and their consequences for our long run goals, the better off we are. Ideally, this is what businesses, investors and markets, and we as individuals operating within them, succeed in doing. It’s precisely the function of markets to coordinate all these plans across individuals, across space, and across time. In other words, it is the unique and critically important function of markets of all kinds to bring short run plans into alignment with long run plans. In the surprisingly complex process of producing even the simplest good, when those plans mesh it’s quite amazing, and very, very cool.
Enter the big problem. (No, not capitalism or ‘excessive’ greed —whatever that means). The big problem is that the future is uncertain. And in the current short run, we face the current series of upheavals—failing financial houses, a riot of home mortgage loans made to uncreditworthy applicants (and the subsequent widespread default on same), and accounting and reporting practices that apparently were used to mask the true the market value of credit and investment instruments.
Is Wall Street to blame? One would think so, from the salvos lobbed at Wall Street in particular and markets in general, and Congress, the Treasury, and the Federal Reserve are more than ready to affix the blame there and move in with the regulatory big guns. A hard look at some indefensible Wall Street behavior is no doubt warranted by our regulators, but before Congress and company turn this into a referendum on capitalism, they need to take a look in a mirror. The existing regulations that contributed to this short term crisis, including the fabulously easy monetary policies of the Fed, its mission to put people into homes even if they could not afford the payments, and other skewed incentives, are significant sources of market instability generated by those in a position to know better.
For economic growth and prosperity, it’s the long run that ultimately matters most. We plan, invest, build and save in the present precisely because the future is uncertain, and the further out we try to plan, the more uncertain that future is. Imagine trying to decide today whether to carry an umbrella to work one year hence. Not much hinges on it, but it’s likely to be a pretty rough guess nonetheless. With decent historical data and a trend line, our predictive odds go up. As for tomorrow’s weather? I can see today’s weather, and listen to forecasts based on current conditions, so—a lot less tough, a far greater likelihood of accurate prediction.
The economic weather is far more consequential for most of us. And a vital function of markets—specifically market prices—is to give as clear a picture of the future as can be had in the present moment. Anything that clouds or distorts that picture will push short term goals out of synch with longer-term goals. We don’t always control the factors that add to future uncertainty, but we certainly ought not to do anything to increase it. Nor should we reward failure, or make taxpayers the scapegoats for failed leadership and unsound practices.
The situation changes daily, so in the FMM’s to come, a rapid look at the role of banking authorities and regulators in the shaping of recent market decisions.