Monday, December 29, 2008

Implications of the Financial Crisis

Recently, I was awaiting a flight from Singapore to New York City and was looking for a good book that might occupy my time during the 22-hour journey. What caught my eye was Dr George Cooper’s, “The Origin of Financial Crises” (2008, Vintage).

In his book, Dr Cooper makes an interesting case for markets being more inefficient than efficient, and further argues that the origins of the current financial crisis stem from the delusionary concepts of economic equilibrium, monetary stability, and rational behavior. Of course, this is not the first book to argue these points.

However, it was the book’s conclusions regarding the near-term monetary and fiscal policy options for responding to the ongoing crisis that struck me. Dr Cooper outlines three options for confronting the crisis, all of them dismally painful:

1. The “free market route,” which entails allowing the credit contraction and underlying asset deflation to play out. In other words, we allow Adam Smith’s “invisible hand” to handle the details of the crisis, while keeping faith with the a priori assertion that “prosperity is just around the corner,” as argued by Herbert Hoover during the 1930’s. Of course, Franklin Roosevelt and his “New Deal” program soon defeated Hoover as support for a new economic approach became a political imperative under the weight of the human suffering and hardships that accompanied the depression. The recent election of Barrack Obama holds parallel implications.

2. “When in trouble, double,” which means continuing to apply fiscal and monetary stimulus in an effort to trigger a new economic expansion that would have the power and momentum to negate the current credit contraction. While this option appears more palatable than the “free market route” at least in the short-term, the long-term implications for debt-fueled spending may only amplify the crisis for future generations. Whether this approach will or can work remains to be seen. However, when one adds significant new spending for universal health care, the imminent social security bailout, and the continuing war on terror into the equation, it seems unlikely that fiscal and monetary stimulus alone can be sufficient.

3. “Unleash the inflation monster,” which is simply “printing money” in order to negate debt through either state-funded handouts or deliberate inflationary spending policies. Despite the fact that this gives today’s borrowers a “get out of jail free card” at the expense of savers, the political implications of this approach may well be the least unpalatable of the three options outlined. Recent increases in the prices for food, energy, and certain commodities provide initial evidence that this approach may already be underway.

After considering Dr Cooper's policy options, I concluded that we are probably already committed to “unleash the inflation monster.” Moreover, I realized that the implications of the crisis are more important than the causes at this point. My advice is that we all prepare ourselves for double-digit inflation within the next 3-7 years and quite possibly sooner. For consumers holding fixed-rate debt, the future looks bright, assuming they can stay employed. For pensioners and those living on fixed incomes, get ready to reduce your lifestyle. As for the government and corporate debt-holders, good luck!

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