I have not been writing for a while, but have been reading about and watching the current economic crisis unfold. This is humbling, and there are many reasons to worry. One of the assumptions behind the sound functioning of markets is that the agents who stand behind demand and supply are well informed and rational. But, as I have argued in many previous blogs, there is reason to question that assumption in the face of widespread financial illiteracy. Of course, my studies of illiteracy focus on consumers, but the current events make me wonder about politicians. Perhaps there is need for a crash course in financial markets and money and banking down in Washington. I do not mean this in a sarcastic way, but rather express it with genuine concern; the lessons we should have learned from the past are seemingly being ignored. My views may be colored by the fact that I was a student of Ben Bernanke at Princeton, but his article on the collapse of the financial sector as a factor in transforming a recession into the Great Depression still resonates (for anyone interested in reading it, the article was published in the American Economic Review back in 1983). It teaches us that the financial sector is vital to the workings of the economy and that shutting it down may send the economy into a tailspin. The role of the financial system in the economy is critical: it channels the funds of savers to the firms and entrepreneurs who need them. Lack of credit prevents not only businesses from investing but also households from consuming and buffering against economic shocks. In other words, a financial system that is not working or that is limping can affect the macro economy and each of us individually. We do not want the economy to go that route.
There is an inherent instability in both the banking system, with its fractional reserve system (only a small fraction of deposits are kept in the banks, so if all depositors wanted to withdraw their deposits, there would not be enough funds to make it possible) and in financial markets, in which large sums of money can be moved very quickly. Several institutions and mechanisms are in place to counteract that instability, one example being the Federal Deposit Insurance Corporation, or FDIC. Some may argue that these institutions do not work very well; for example, what banks pay to be insured by the FDIC often does not reflect their actual risk. In reality, financial markets continually innovate. Moreover, financial instruments have become very complex in terms of risk. Derivates, such as options and futures, make it possible to take up large amounts of risk. Regulation has certainly not kept up with that.
When a financial crisis occurs, it is important to act quickly. Now more than ever we need to have economics and finance rule politics.