Feb 1, 2009

On the Philosophy of Economics during Financial Crises

A year ago I was costumer of two private banks. Today, I am costumer of two state banks and it would be a lie to say I am unhappy about this. Since, I did not transfer myself to China, it is a reasonable question to ask how this came about and more interesting even what is likely to follow.
Governments in the Western world have started a big shopping tour. The idea of a small state has been thrown overboard and government intervention is top on the priority list not only of politicians but of academics and managers alike. There are good reasons to be in favor of state intervention when markets fail. The problem is the cost and incentives this creates. And in the end we need to weigh cost against benefit to evaluate the attractiveness of such a policy.

Unless it generates an incredible high multiplier effect, the intervention will lead to a transfer of wealth from future taxpayers (including me) to the current ones (including all the people who make the current decisions). Besides this annoying fact, there is an even more troubling dimension about the management of the current crisis.

A simple implication of the crisis management, may state that it is optimal to have state control under distress and leave the market to rule in good times (nothing new for Keynes). There is one technical flaw in this line of reasoning and one deeper flaw. The technical one is the following: “Who declares when we have a crisis? And what are the criteria?”. Presuming this non-trival problem had a solution, we would get to the more severe problem. If then state control becomes predictable will the market still be efficient in good times or lead to an increase in moral hazard. These are not new ideas. But if you carry the reasoning one step further, you are likely to conclude that if crises are more frequent (and here I am not necessarily thinking of western countries) and “temporary” state interventions lead the private sector to behave excessively risk taking in good times, it might be less inefficient to let the state run the whole thing form the beginning on (presuming it is a “good” state)..

I guess the fact that the world has converged to the capitalist system is a proof of the fact that we consider the costs of rare negative events to be outweighed strongly by the benefits in good times compared to the permanent inefficiency of state control (With the exception of Cuba and Bhutan). To keep this wisdom alive government intervention policies must ensure that the right people pay the cost. And I haven’t figured out yet what my contribution to the recent crisis was. Any ideas…

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