The Next Financial Crisis

Tyler Cowen writes,

When the U.S. real estate bubble burst in the late 1980s, there was a downturn in output and employment but no financial crisis. No capital markets froze up for instance and risk premia never deviated much from normal in the first place. And if that late 1980s-like path is what someone is predicting for the Nordics, Canada, or Singapore, well maybe so. I’m not predicting it myself but I certainly can see that within the realm of the plausible.

Much is within the realm of the plausible. Too much.

If you are a creditor of a government or of a large bank, your thoughts are probably along the lines of, “All of the governments and regulators of the world are doing everything that they can to prevent me from suffering from a default. So I’ll just hang in there.”

That is one equilibrium. But it is easy to transition to another equilibrium. Suppose that, in spite of all the best efforts of the same folks who were not able to stop the financial crisis of 2008, there is a large painful default by any one of the countries on Tyler’s list. If that happens, then a likely scenario is that all of the rest will go down very quickly.

The current policy approach perhaps reduces the probability of any one nation or one bank going under. However, it increases the probability of a huge, horrible, systemic collapse. A benefit of reducing government budget deficits is that it helps to reduce the probability of this Armageddon scenario. Even if you believe that reducing government deficits is painful austerity, from my perspective the benefit exceed the costs.

1 thought on “The Next Financial Crisis

  1. And now there are those within the federal bureaucracy who intend to examine whether or not “regulators” should determine the range of managerial discretion at Berkshire-Hathaway.

    Such trends are toward restricting the diet of the golden egg-layer rather than killing it outright. Eggs will probably continue to be laid by their composition will differ from the historic past and resemble those produced by “programs.”

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