Sunday, September 13, 2009

Krugman's Economic Roundup

Wow! Do they have a Nobel Prize in journalism? No on second thought, using a term synonymous with noble together with "journalism" is a bit oxymoronic.

Anyway, Krugman's roundup of just how all - or most - of the economists got it wrong in the recent economic unpleasantness renews my faith that the American economy is still the poster child of chaos theory. Perhaps the Keynesian economists and the free-market thinkers are nothing more than strange attractors in chaos theory.

Two things not mention in Krugman's article – or maybe it was and I just missed it – was expectations of investors and the other was the Cold War.

In the collapse of the whole sub-prime based financial investment instruments, if only investors had known the true risk. These packaged risky investments did not have the diversify risk their rating would seem to indicate. The rating houses did a great disservice to the economy. They sold their souls (their credibility) to the devil for the huge revenues to be made rating this new investment. The rating house that gave the highest rating to these new untried and untested instruments got the most business, and of course, profits. Had investors known the true risk involved with these sub-prime backed instruments, the risky investments would have only been for those who like to take risk – market players.

The sub-prime backed investment sellers would not have been as able to raise money to further their risky operation by loaning more money to those that any rational evaluation tells you they cannot pay. The eventual economic collapse may have been more the usual restriction or downturn, not the wiping out of investment strategies. The rating houses work for the seller not the buyer, and it should be the other way around. Their incentive should come from how well their rating of a bond proves true, not how much business they can get from the sellers.

Next, the winning of the Cold War at the end of the previous century proved that free markets are more productive than planned economies. The strategy of détente was the most important decision made during the Cold War. It was not the forces with the strongest, most powerful army but the one with the more efficient economy that won, and this could only occur if peace reigned. Like the legend of the emperor with no clothes, communism's centralized planning, no mater how well controlled or planned, could not keep up with free markets – and with peaceful co-existence, everyone could see it and acted accordingly, and communism as a future economic concept began to die. While not all countries of given of the communist ghost, they will always be at a disadvantage against free market economies.

What lesson can we learn from this? While I like the headline: If it's too big to fail, it should be regulated. In our rush to fix what we perceive as problems in a free market, let's not do away with what drives, incentivizes, and produces the return that so recently defeated a more plotting and planning foe.

A simple tweaking is all that is needed. Re-direct the incentives for the rating houses, but leave the free market, and in this case, the free financial market alone. Had the riskiness of the sub-prime investments been shown in the lower than acceptable ratings, investors betting the rest of their lives would not have bought it, and the sub-prime back investments would have been the playground for those players looking for risk.

And we could have all lived happily ever after.

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