Apr 6, 2009
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Fantastic Analysis and Solution to the Current Financial Crisis
Two top economists (one a Nobel prize winner) provide an excellent analysis of the current financial crisis. While they don’t say it, it also points to a counter-intuitive solution to the problem. Its all in the hands of the American consumer.
Their main hypothesis is that this current meltdown is very similar to the meltdown that led to the Great Depression. Both were caused by massive consumer debt.
“It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.” Steven Gjerstad and Vernon L. Smith, in The Wall Street Journal.
In short, people without money owned things they couldn’t afford. This was made possible by an all too willing financial and banking system that had government incentive to supply the purchasing power for the spending spree.
Four facts that are particularly interesting in the article:
1. The Dot-Com collapse wiped out about $10 trillion of value in the stock market but had minimal impact on the whole banking system.
2. The Consumer Debt Crash (the current crisis) wiped out only about $3 trillion of value in the stock market but has devastated the entire world banking system. Why? That’s much of what the article addresses.
3. Inflation in 2004 and on was much, much higher than reported due to a change in the way it was calculated. It was more like 6% instead of 3%.
4. Ben Bernanke seems to think like authors of the article. He wrote a study on the Great Depression in 1983.
Ben Bernanke is the current Chairman of the US Federal Reserve Bank. Understanding his thinking can help people make sense of what the government is trying to do to solve the current crisis. It gives us a better background to judge whether leaders in Washington are doing the right things or not.
On the causes of the current Consumer Debt Crash here are some of the factors the article lists (all taken directly from the article):
- Rising household income that began in 1992
- The elimination in 1997 of taxes on residential capital gains up to $500,000
- Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income
- Rating agencies accepted the hypothesis of ever rising home values
- The fed-funds rate, by December 2001, had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession.
- Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded.
The authors end on a very academic note saying that “the causes of the Great Depression need more study” and suggesting that that would be helpful to understanding the current crisis. No doubt that’s true.
To me the article points the way to a counter-intuitive solution. The consumer needs to re-assure the financial system. (The government’s propping them up doesn’t seem to make a difference.)
Individuals need to show the banks that once again we will buy and spend. We have to show confidence that at some point we know there will be plenty of jobs in the future. There needs to be an obvious and clear signal to the banks that people haven’t given up on the system as a whole. But, on the contrary, that we will once again pick ourselves up and start to create the tremendous wealth this country is capable of producing.
[...] Gaijin Guide put an intriguing blog post on Fantastic Analysis and Solution to the Current Financial CrisisHere’s a quick excerpt1. The Dot-Com collapse wiped out about $10 trillion of value in the stock market but had minimal impact on the whole banking system. [...]
The Great Depression has already been completely analysed and explained. Von Hayek, who won the Nobel prize in Economics, was a “Austrian” economist. This book, by another Austrian, explains it all. Note the enthusiastic foreward by noted historian Paul Johnson (or maybe Johnston - I forget…)http://mises.org/rothbard/agd.pdfHere is another thought provoking viewpoint. If your thought processes are crippled by politcal correctness, don’t bother reading….[I removed the link -Mark Phillips]…markb
@markb I’m a big fan of both Hayek and von Mises. They are pillars of understanding trends and forces in an economy. Recovering from the current crisis, though, requires specific analysis of the institutions, financial instruments and economic actors involved. That way, specific policy can created to deal directly with those factors. As the analysis cited in the blog post discusses, the Great Depression is the closest other example to the economic crisis the U.S. is in. So, by studying it further and in more detail, particularly those elements which seem to be the same between then and now, we can at least run some theoretical test cases or what-if type scenarios before trying things out in the live, real world environment.I removed the link to the other article you posted about. It struck me as being more inflammatory rather than contributing to the analysis of the crisis or the discussion of a solution.