Unforeseen Contingencies

In the 14 September NYT Paul Krugman writes that he doesn't think the U.S. financial system is about to collapse. He's rather hesitant, so I might as well be bold: he's wrong. The catastrophe I suggested (e.g. my 1 December 2006 post) is upon us. The financial system is collapsing.

Not that I am especially prescient - what's happening is exactly what NYU's Nouriel Roubini has been warning us about for quite some time, the creation and eventual collapse of a house-of-cards credit system in the United States, which in turn is an updated version of the credit-driven "Austrian" business cycle of Ludwig von Mises. Roubini is now arguing (in a 16 September post "The Worst Financial Crisis Since the Great Depression") that it's too late to avert disaster, and that the only light at the end of the tunnel is the coming financial train wreck. He predicts the destruction of the investment banks, insolvency for a number of real banks (and FDIC), freezing up of credit markets, insolvency for American consumers, all resulting in a deep and lengthy recession for the U.S. and Western Europe, with fallout in emerging markets as well. Now that's what we mean by "financial collapse." The post nicely explains his reasoning, most of it hinging on the phony bookkeeping (he calls it "liar accounting") that has permitted, and still permits, investment banks to pretend that toxic waste is a valuable asset.

(I believe you'll have to have an RGE Monitor account to read the post, but if you can get it, read it.)

Roubini also has a very nice presentation - academic, but decidedly non-technical - of the economics and policy of financial crises, and this one is free for the downloading from the World Economic Forum (check out Chapter 1.3). It's here he makes the link between asset bubbles and easy money from a central bank.

I mention all this in the hopes that my few readers will avail themselves of these reading opportunities, because the more people who understand what is happening, the better, particularly since our would-be leaders are hopelessly lost on this one. (Can any of them be more clueless than Sarah "Freddie and Fannie were becoming too great a drain on the taxpayers" Palin?)

So is economic ruin really upon us? I suppose it depends on what is meant by "economic ruin." The world won't end, but the United States are coming against a hard budget constraint, and it's going to hurt. The only immediate way out of the financial mess that anyone can think of involves federal bailouts. But the Federal Government is itself insolvent, so a bailout means, umm, foisting this off on the Chinese? raising taxes? inflating the currency? If we had substantial surpluses, a bailout wouldn't seem threatening, but we don't. To the contrary, given good economic conditions we face exploding entitlement payments that threaten to sink us. And conditions are bad.

A crackup of the financial and economic systems seems inevitable to me. That doesn't mean the end of the world, but it does mean we'll be building new systems. And what we build will depend on our understanding of what went wrong. I'm hoping people will wake up and realize what is happening, and that this isn't simply the natural vagaries of the unregulated free market; it's corruption and criminality, abetted by interventionist government bodies. The solution isn't socialism, it's genuine free markets.

(Roubini often blasts free-market dogmatists, and he doubts that truly free markets will give the incentive to fix the problem. Maybe at some point I'll explain what's wrong with this part of his story.)