Today stock markets around the world have taken another dive. More interestingly Treasury bonds have also gone south in the last few days. Because of the bailout, large quantities of Treasuries have been offered for sale and that has depressed bond prices. It seems like the US Treasury will have problems finding all those funds to rescue the financial system. If more borrowing and more liquidity won’t work then we’ll ultimately be left with raising more taxes. In the current economic climate, this will be a very difficult political endeavor, but it is also unlikely to bring more revenue. (Incidentally, it is scary to see that 54% of economists in a recent WSJ survey think that the next president should launch an economic-stimulus package in January ’09.)
Legislators have no more tricks left to use. Wherever they turn, they face the only option they have been avoiding for years: market adjustments of asset prices. Ultimately, there is no way to avoid the necessary adjustments. There is a gigantic cluster of error in the pricing of assets in the US economy and it has been going on for too long. Asset price adjustments cannot be delayed indefinitely by government rescue plans. It is going to be painful for those who will end up loosing equity, but this equity did not exist in the first place, it was an illusion brought about by government monetary policy and financial regulation.
I must say here that Ed Weick, a friend of Pete Boettke and me, has been warning us about an impending financial crisis and credit crunch for more than five years. He simply used Austrian analysis and applied it to what he observed in financial markets (he must be one of the best investors out there). Austrian theory cannot do point prediction, but can decipher forthcoming patterns. Ed Weick was right about all this.
In a post last March, I explored what one can do to protect one’s own assets in period of financial troubles (buying gold was a major option). It is going to be difficult to shelter oneself from the consequences of the current storm, especially as we do not know how long the adjustment will take. However, as it is generally the case in financial crisis, securities experience wild variations in their prices but eventually those that were not mispriced in the first place recover. The question is one of the fundamental quality of the underlying assets.
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As a side note, my colleagues Veronique de Rugy and Philippe Lacoude wrote an interesting article on the crisis for Reason online. They argue that many low-cost policies could be implemented to improve the situation. While I don’t agree with their position on the mark-to-market accounting rule, the article provides a fresh look at the situation, as they believe that the existence of a lender of last resort is a major source of perverse incentives in the system and that this combined with poor SEC rules on investment bank capital ratios has had deleterious effects.
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