Raise the Hammer

Ryan >> In a "free market", you would have a cascading collapse of financial institutions - including irresponsible and responsible firms alike - followed by a general collapse of the financial sector and then the economy as a whole.

This depends on how people reacted. If depositors realized that their money was actually locked up in the value of people's homes and businesses, they could simply choose to accept lower payments for a while, until such time that demand for homes picked up. It's only because people are led to believe that their money is actually stored as cash, that they have the expectation that they should be able to pull it out in full, whenever they want. Government backed deposit insurance helps foster this untruth.

>> Just look at what happened when the Fed allowed one company, Lehman Brothers, to go under - an instant dramatic credit squeeze and asset price collapse that vastly exceeded the size of the Lehman bankruptcy itself.

So what? A credit squeeze simply means that investors don't know who to lend money to. In an economy where there are transitions from one type of output to another (housing to something else), this takes time. However, if the government truly wanted to free up capital, it could cut its own spending, thereby increasing the capital available to businesses and individuals, thus making it easier for the private sector to make new investments.

Instead, Obama feels it necessary to be in "control" of where taxpayers money should flow, in particular to bad companies like AIG and other banks that screwed up. Take limited capital, give it to the banks that messed up, thereby reducing the capital that can flow to smart banks and businesses that didn't. Makes a lot of sense.

>> The current crisis is extensively due to the overexposure of an unregulated "shadow" banking system that borrowed and lent at high risk in complex and heavily leveraged arrangements of mortgage backed securities,

Yes, many banks made highly leveraged investments, so they should fail.

>> The crisis is a cascading spillout from what amounts to a stream of panics and 'bank runs'

Panic comes from a lack of knowledge. If the government told the truth about what banks really are, this would soothe many people's fears.

>> your prescription - big surprise, tax cuts - will do little to stimulate the economy since most of the money goes into low-risk savings rather than investments or spending.

The economy doesn't need stimulating. In fact, stimulating demand in an economy that isn't increasing real output simply leads people further into debt (paying for Chinese imports by borrowing from the Chinese people) and/or higher inflation. If you actually want to help the economy, you need to increase output and one way to do this is to increase the amount of work being done. This could be done by inviting back the people that left when the government started cracking down beginning in mid 2006. Alternatively, you could drop the minimum wage, thus making it easier for businesses to hire workers. With more workers, real output would increase, profit margins would increase and businesses would have money for new investments.

>> You're basically trying to push a piece of string from the supply side when you should be tugging on it from the demand side.

Demand is infinite, it doesn't need stimulating. Personally, I would be more than willing to buy 100 homes if the government gave me the money to do so, but this would mean that other people would have less money. If the goal is to take Chinese money, this eventually has to be paid back, so you are simply borrowing from future consumption. The only true way to increase economic output is to either bring in more workers, or increase productivity.

Increasing productivity requires access to savings, but it also requires good ideas. The government can take taxpayers money and give it to banks, but they can't give them insight as to where to invest to come up with these new ideas. This requires private sector expertise. If the government would just stop trying to force economic growth and let investors sort out the good ideas form the bad, the economy would re-balance itself automatically.

Furthermore, if you think that the Great Depression was caused by the free market, here is a 1932 quote from Herbert Hoover that dispels this idea...

"We might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action…. No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times…. For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered…. They were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.

Creating new jobs and giving to the whole system a new breath of life; nothing has ever been devised in our history which has done more for … "the common run of men and women." Some of the reactionary economists urged that we should allow the liquidation to take its course until we had found bottom…. We determined that we would not follow the advice of the bitter-end liquidationists and see the whole body of debtors of the United States brought to bankruptcy and the savings of our people brought to destruction."

There you have it, so much for the free market. Hoover fought to help the "common man and women", to the extent of driving business profits to zero. The result was a massive reduction in private sector investment and a lot of pain for the very people he was trying to help.