MARKET DISCIPLINE MEANS ALLOWING DEPRESSIONS

Today, July 13th, the Fed and the treasury announced that they are setting up guarantees for Freddie Mac and Fannie Mae. I expect that there will be a whole set of outraged people on the left who are protesting the “bail out”. What these people do not realize is that a policy of “…let the big boys suffer…” will only lead to suffering for the little guy. The last time we had economic problems of this magnitude was in the late 1920’s and early 1930’s. At that time the Fed and the treasury took a “...let the chips fall where they may…” attitude. The Fed failed to act as a lender of last resort and there were multiple bank failures which brought the economy to a screeching halt and led to the Great Depression.

The world has changed and many of the roles played by commercial banks in the 1920’s are now played by other forms of financial institutions. The Fed’s mandate, however, was set in that earlier era. If the Fed is forced to deal only with its original mandate then massive failures of financial institutions will lead to another Great Depression. Ben Bernanke is to be commended for finding innovative methods to deal with issues that go beyond the Feds original charter.

We do need to remember how we got into this mess. The root cause of the problem is the belief that market discipline will keep excess risk under control. The problem with this attitude is that it forgets that the ultimate form of market discipline is a depression. A depression forces all those who engage in excessively risky behavior to suffer financial loss. The fact that innocents would also suffer is not included in the equation.

As the last depression was winding down, a whole set of laws and regulations were enacted. They were designed to prevent a future depression from occurring. However, the Regan Era mantra of “Market Discipline” caused us to relax or eliminate many of those regulations. People who should have known better said “…the discipline of the market will prevent a future Great Depression…” What they forgot was that the first Great Depression occurred when regulation was non existent and “Markets Ruled”. If market discipline worked to avoid depressions then the Great Depression never should have occurred. There is a simple equation:

Unregulated Market Rule = Potential Depressions