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Federal Reserve Chairman Ben Bernanke has a theory that the great depression was caused by a loss of confidence in the banking system. He's trying to prevent that now by injecting cash into the system.

The problem is that confidence isn't a concrete thing like cash. It's a psychological thing: more about trust and sense than about dollars and cents.

If you wonder what's happening to the stock market - or to your retirement plan - right now, it's directly related to lack of trust in Bernanke, and in the government in general. The stock market trusts capitalism and the private sector; the more government intervention it sees - especially with talk going around about nationalizing banks and such - the less confidence it has that stock certificates mean anything, and the lower the value it assigns to those certificates.

The answer is not, as Bernanke and Paulson and Bush and Pelosi seem to suggest, more intervention. The answer is for the government to back off and let the free market do its thing.
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On October 11th, 2008 06:58 am (UTC), psychohist commented:
And here's a video that illustrates how government intervention can distort the free market, helping to create this kind of problem - in this case, encouraging imprudent subprime lending that helped cause the current problem.

Unfortunately, while providing many relevant and interesting facts, this video tries to use them to present a partisan message, to the point where I wasn't sure whether I wanted to link to it. I think I'm going to just trust my readers to do their own filtering. Just be warned that, while the background information and the discussion of the development of the mortgage crisis seems right on, the ties to political parties and personalities are questionable.

Also, keep your cursor over the pause button if you really want to absorb it, as the information is presented at breakneck speed.

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On October 13th, 2008 05:45 pm (UTC), dcltdw commented:
In your non-intervention model, how bad do things get before they get better?
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On October 14th, 2008 01:54 am (UTC), psychohist replied:
Hm ... that's kind of a general question. For the moment, let's assume we're not talking about being able to retroactively change the damaging decisions already made, but that on a going forward basis we can change course by doing the following:

- cashier Bernanke and replace him with a real inflation hawk (Fisher, maybe)
- rescind Paulson's $700 billion
- going forward, existing mechanisms are used: the Fed will use a free hand to manage the money supply and FDIC insurance will back up the banking system as necessary
- the new leaders will focus their public statements on how we are going to successfully handle the issues, as Greenspan and Reagan did in the S&L situation, rather than focusing on how the sky is falling in and running around like chickens with their heads cut off
- repeal the regulatory incentives to make subprime loans - if we want to make home ownership easier, use guarantee mechanisms like VA and FHA insurance
- in the longer run, consider restoring the barriers between commercial banking and investment banking so the investment banker pals of Bernanke and Paulson don't get us into worse trouble next time

What I'd expect to happen with respect to the banks and mortgages:

- Custodial banks would be fine. People who invested IRA money in REMICs would take a loss, but nonidiots always knew they were risky investments anyway.
- Retail banks would largely be fine; any sluggishness in interbank loans could easily be made up for by loosening restrictions on the discount window. Most retail banks do not have terribly large exposure to the mortgage crisis since they act more as loan originators than as loan holders. A few, like Washington Mutual, may fail and need to be sold off with the FDIC possibly making good on some insurance, but fundamentally sound banks who face unfounded panics, like Wachovia, will be able to weather them using the discount window and would be snapped up if they went up for sale anyway.
- Some investment banks would fail due to holding too many mortgage backed securities. Too bad. They made bad investments; they should take the consequences. Their stockholders likewise get to take the consequences, and the bondholders will be paid off at 90-95 cents on the dollar instead of 100 cents. That's how stocks and bonds work.
- Some of the people who took subprime mortgages will be foreclosed on, and the people foreclosing on them will take a loss as well. The lesson here is, lend and borrow wisely.

What I'd expect to happen to the stock market: it would recover above 10000 fairly quickly, and stabilize above 12000 after a year or two, then continue from there. On an inflation adjusted basis it would do significantly better than it will under the current course of action.

What I'd expect to happen to the economy at large:

First, as background, we're way overdue for a good recession. The last actual recession happened in 1991 - what people called a "recession" in 2001 didn't actually meet the definition of two consecutive quarters of negative growth, and what some people are calling a "recession" this year is in fact anemic expansion. Those used to the robust growth of the 1980s and 1990s need to remember that growsh was primed by genuine recessions in 1980 and 1991.

The reason growth has slowed is because, after 17 years without a recession, the economy has developed a lot of unproductive fat. This happens during fat years: companies hire less than carefully, then keep employees even after they no longer have work to do. It takes a recession to shake this pattern - to force the companies to lay people off so that those people will switch to jobs where they'll be doing productive work instead of unproductive work.

My suggestion would likely result in a near immediate recession. This would be a good thing, as it would allow people to switch to more productive jobs and companies to focus on what they do well, setting the stage for perhaps another decade of robust growth.

I consider that much better than what will happen if things keep going the way they have been: at best, this year's anemic economy will continue for a decade or two; at worst, we enter a hyperinflationary spiral that in historical cases has typically resulted in complete economic collapse.
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