Two Brief Histories of the Crisis

This week’s Economist offers an excellent short history of modern finance. Here are the first two graphs:

THE autumn of 2008 marks the end of an era. After a generation of standing ever further back from the business of finance, governments have been forced to step in to rescue banking systems and the markets. In America, the bulwark of free enterprise, and in Britain, the pioneer of privatisation, financial firms have had to accept rescue and part-ownership by the state. As well as partial nationalisation, the price will doubtless be stricter regulation of the financial industry. To invert Karl Marx, investment bankers may have nothing to gain but their chains.

The idea that the markets have ever been completely unregulated is a myth: just ask any firm that has to deal with the Securities and Exchange Commission (SEC) in America or its British equivalent, the Financial Services Authority (FSA). And cheap money and Asian savings also played a starring role in the credit boom. But the intellectual tide of the past 30 years has unquestionably been in favour of the primacy of markets and against regulation. Why was that so?

Berkeley Economist Brad DeLong offers a humorous recent history of the various bailout and government intervention attempts in the Guardian, “From Plan A to Plan G”:

I am an economic historian. An occupational disease of being an economic historian is to insist that the answers to all questions lie in the Great Depression that started in 1929. When the financial crisis hit in a sudden squall in August 2007, in the back of the Federal Reserve’s mind was that it should not repeat any of the mistakes that led to the Depression. Hence Ben Bernanke and his Fed loaned extraordinarily freely to banks and near-banks and non-banks in order to avoid what Milton Friedman said was the key mistake that made the Depression Great: that the Fed had triggered or allowed a liquidity squeeze that made cash hard to get. Call this Plan A.

In a couple of months it became clear that Plan A was not working. The economy was weakening. And the Fed remembered the theory – put forward by, among others, Lawrence Summers and myself – that what made the Depression Great was that businesses began to expect deflation. The expectation of falling prices made every business postpone its investment spending – better to wait a year and build your plant and equipment then when prices were cheaper – and so private investment collapsed. So Bernanke and his Fed lowered interest rates to what they thought were levels that might trigger inflation, as a way of making sure that no business anywhere would even begin to suspect that a deflationary spiral was in the making. That was Plan B.

The plot thickens, of course, and eventually winds its way to the current Plan F, and the possible dramatic Plan G:

If Plan F fails, we move to Plan G: we pull the Keynesian fire alarm and begin an enormous government infrastructure building programme in the whole North Atlantic to keep away depression.

Two notes: DeLong is American, so I doubt he actually wrote ‘programme’ and the phrase “Keynesian fire alarm” is too awesome not to re-use. It sounds like some sort of hilarious game. Hm.

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  1. The financial crisis actually began twenty or more years ago when capital discovered – again – it could expand itself more aggressively by speculating in debt than it could by investing in plant and equipment and higher wages to fuel the demand side. LTCM was instructive, in retrospect.

    Making cash easier to get is hardly the point when the problem was caused by there being no good place to put all the cash that speculation generated in the first place. So the Keynesian fire alarm is gonna get pulled sooner or later, I’d say, but not before a serious contraction of the finance sector of the economy back to a more balanced relationship with the production sector.