Wait... What "Crisis"?

I make mistakes like everybody and I tend to panic a bit too, when the Treasury Secretary talks about another 1929. But what is it that's wrong at the moment with financial markets? It may well be that the correct answer, simply put, is that short sellers are having a field day with all the highly leveraged assets out there. So here's a thought experiment: What would happen if all the credit default swaps and all the other exotic derivatives instruments suddenly just disappeared, not to be replaced? My best guess is that the economy would continue to sputter along pretty much as its been doing, perhaps with a slight uptick due to the removal of net, persistent overhanging shorts. It's far from being a healthy economy but we're a good distance yet from outright collapse, unless that collapse were brought on deliberately.

To put it somewhat cynically, credit default swaps (not to speak of other derivatives) are the rough equivalent of you taking out insurance on your neighbor's home — which you then have an incentive to burn down. Will the hedge funds try to crash the U.S. economy? I suspect yes, they will if they can. And now they're plenty large enough to try.

The Treasury and the Fed see a seizing up of credit markets and diagnose a lack of liquidity, so their solution is to inject more money into the system. But the real problem is that when pressured by short selling financial institutions do not know how to value their assets and without that knowledge refuse to lend each other money.

As much as I hate to agree with Alan Meltzer (who's almost as bad as Milton Friedman ever was) he's probably right to point to similar, past crises around the world that were resolved by the governments in question loaning money, at market rates, to distressed financial firms; some would avail themselves of the bail-out, others would sell themselves at a discount. Indeed, we've already seen the latter happening without government intervention. And those sales tell everybody what the real mark to market price of assets actually is.

As I've said, I'm OK with bailing out AIG, and I think it was fine to let Lehman fail. But where's the crisis now? Maybe we don't have to go as far as Meltzer suggests but it's worth taking a moment to consider as an alternative to a huge bail-out a step by step approach that doesn't put a mind-boggling price tag on the problem but instead lets the market start to sort through the mortgage derivatives wreckage. Instead of $700 billion what about $100 billion, split between the smaller banks and main street? Or, more radical still, what about passing a law that makes derivatives from that point forward illegal and unenforceable in U.S. courts (at least until they can be regulated properly)? The bad paper already out there can fend for itself.

There are probably a number of different ways to effectively handle the present situation that don't look anything like Paulson's proposal. And common-sense suggests we shouldn't trust what the Administration tells us. Especially not when we go from 'everything's fine' one week to a five alarm fire the next.