Friday, October 3, 2008

On Second Thought

Now that the House has reversed course and the bailout legislation has become law, we will get to see just how much the federal government is able to impact the economy. There seems to be a broad consensus that things are going to get worse before they get better, but how bad and for how long no one knows. No doubt the next months and years will bring forth many accounts of how we got here from there, similar to what happened in the wake of Enron, only a much larger scale.

Why Did We Need To Do Anything?

Much of the coverage of the economic news over the last few weeks has focused on individual firms (Lehman, AIG) or on a stock index like the Dow. While these make for better narrative in news coverage, they are not the reason federal action was necessary. Largely buried in the news were references to the status of credit markets. These references usually included words like crunch, squeeze, tightening, or freeze. These descriptions are in contrast to the normal state of affairs in which credit markets are generally very liquid.

It it easy to think that what happens in the credit markets doesn't impact the average person unless they are in the market for a house or a car right now. But these markets, where money moves from where it isn't needed to where it is needed, is central to the functioning of the economy as a whole. When these markets are discussed, they are often compared to blood or grease - something that keeps systems moving. The latest turmoil has inspired many comparisons to the Great Depression, so it is useful to look at that period in history to see just how important credit is to the economy. Historian Niall Ferguson, writing on, invokes Milton Friedman on this point:

Yet the underlying cause of the Great Depression — as Milton Friedman and Anna Jacobson Schwartz argued in their seminal book A Monetary History of the United States: 1867-1960, published in 1963 — was not the stock-market crash but a "great contraction" of credit due to an epidemic of bank failures.

Given this, it's hard to see how the federal government could not act.

Shelly says my extreme ideology should only be taken in small doses, so I will stop there.

Up next: Why can't we just stop borrowing and live within our means?

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