Tuesday, May 13, 2008

Economics matters

From time to time, I'll post on various economics issues. I just graduated from Dalhousie University in Halifax with an economics degree, so it's a subject that I remain quite enthused about (I know many people are bored to death by it, but don't worry, I won't ever get into anything too technical).

To start with, Robert Kuttner has an informative article on the subprime mess and why Europe is not experiencing similar problems:

The credit crisis, which is sapping America's economic strength, was the result of an almost religious belief in deregulation whose excesses are now coming home to roost.

It is instructive to compare the American financial mess with the economic situation in nations that resisted deregulation. Old Europe tends to get a scornful press in the U.S. But Europe is not suffering a financial meltdown today -- mainly because Europeans (with the exception of Britain and Switzerland) took only a few sips of the financial Kool-Aid so heavily promoted by U.S. banks.

Generally, you don't want important industries to be heavily regulated; regulation adds administrative complexity and market inefficiency. But a balance must be struck, and regulation in the American financial sector was sorely out of balance.

In this business, nothing is more important than confidence in the system. The ultimate fear is a dreaded "run on the banks", meaning everyone scurrying to withdraw their deposits from institutions at risk (or perceived risk) of insolvency. It's basically a panic, and panic is contagious and self-sustaining.

This is but one reason why some regulation is necessary. Absent hard and fast rules, risky instruments like subprime mortgages and their derivatives will invariably arise in the pursuit of profit. Of course, it doesn't help when your central bank spent most of the nineties and 2000s promoting ever more debt creation and real-estate/credit bubbles. The Fed must take its share of responsibility for this.

No comments: