Sub-prime - just another banking crisis

First, this time could be different. This time the market mechanism may fail to self-correct and fragilities that have been accumulating over time may be too great to overcome. This is always a possibility. The “this time it’s different” argument is very popular, but cool hard-headed analysis suggests that while the actual crisis trigger varies from crisis to crisis, the actual unfolding of the crisis is much the same each time. If anything the number of failed US banks in the current crisis is much lower than the Savings and Loans crisis of the late 1980s and even the Great Depression.

A second possibility is that the hysteria is all a media beat-up. John R. Lott Jr, author of Freedomnomics, has argued that some perspective is in order. Economic statistics for the US, apparently, are slowing but nonetheless the economy remains strong. Lott’s argument is that a left-biased media is playing up the bad news as part of a plan to elect a Democrat to the White House. He says this is a mirror image of the 2000 election campaign when the media covered up a recession to promote Al Gore.

There are, at least, two problems with this argument. First, the NBER date the US recession from March 2001 - so the factual basis of Lott’s argument is weak.

The second, more serious, problem is that Lott is promoting a conspiracy theory on a grand scale. Not only would the media (who themselves are not a single conscious monolith) need to participate in the conspiracy but the “smart money” in the betting market would also have to participate too. Of course, that does not undermine the argument that the media may be left-leaning, but it does suggest that recession fears are more than just a media conspiracy.

The third possibility relies on a behavioural belief that Bryan Caplan documents in his recent book, The myth of the rational voter: Why democracies choose bad policies. Caplan argues that people have a number of biases that inform their perspectives on life. One of those biases is a pessimistic bias. People have a tendency to overestimate the severity of economic problems and underestimate the performance of the economy.

It is true that the economy, both in Australia and in the US, has experienced some turbulence and volatility. Yet responses to the crisis seem to be all out of proportion to the crisis itself. Calls for greater disclosure, for example, ignore the fact that investors already have a lot of information. One more piece of incomprehensible accounting data will not suddenly reveal all. Calls for greater regulation of financial markets also ignore the fact that we have yet to see whether the existing, already onerous, regulations have failed. There is no evidence to suggest that the financial system or economic order has failed to work as expected.

The bottom line is that people who make poor investments or have poor business strategies should lose their money. Over the past year that is what we have seen. It is not the end of the world, or the beginning of the next great depression. It is the market at work.