Andrew Lilico is a Director of Europe Economics, the Chief Economist of Policy Exchange, and a member of the IEA/Sunday Times Shadow Monetary Policy Committee. He writes here in a personal capacity.
Governments are typically able to respond to significant events employing one of four broad strategies:
- Try to keep things as they were
- Manage change, slowing and smoothing the transition
- Permit change, allowing matters to proceed at their own pace
- Embrace change, trying to reach the new stability more quickly
In the 1930s, in response to the Stock Market Crash and the early phases of the slowdown, the US government went for strategy (4). It deliberately tightened policy so as to try to accelerate change. It saw this as economically efficient and morally improving. As Andrew Mellon put it at the time:
“liquidate labor, liquidate stocks, liquidate farmers , liquidate real estate to purge the rottenness out of the system. High costs of living and high living will decline. People will work harder, values will be adjusted, enterprising people will pick up from the less competent.”
As our current crisis began in 2007, the broad strategy in many countries was to attempt to keep things as they were. Many people saw the problem in financial markets as either a technical flaw in the way financial markets were working, or a passing liquidity problem, or in some cases the result of deliberate market manipulation by speculators. The idea was that government intervention to provide extra liquidity, intervening in specific markets in some cases, or simply replacing bank-to-bank financial dealings with bank-to-central bank dealings (e.g. though the Special Liquidity Scheme) would shield the market through its temporary glitch.
By summer 2008, this approach had clearly failed. Instead of fading away through government intervention, problems continued and escalated. Governments then hit upon a new concept of how to keep things much as they were. The idea now arose that instead of a liquidity crisis, what we faced was a crisis associated with past losses. Some poor decisions had been made, leading to large losses. But if governments intervened to replace the funds lost (to “re-capitalise” the banks), then looking forward matters could continue much as they had done before. There was a debate as to which governments would do this. Initially it was hoped that oriental sovereign wealth funds might re-capitalise the Western financial system. After the Fannie Mae and Freddie Mac debacle, this ceased to be an option, and instead Western governments intervened to re-capitalise their own banks.
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