On the Faux-Puzzlement of Dan Davies
The Global Financial Crisis scarred global economies for a decade; COVID did not. The difference was cash, certainty, and a lender of last resort. Bagehot wrote the manual in 1873; Keynes added the addendum in 1936. Economists misplaced both. As Don Kohn said at the time, in dealing with a financial crisis: “Go fast, go hard, go soon”—and fix moral hazard later. Policy knew this once; it should again…
The Great Financial Crisis was not a destructive hurricane that laid waste to the fundamentals of wealth. It was, rather, a head injury to the economy’s coordination system. The muscles that drove the engine of wealth were still there, but useless for a long time. For when uncertainty about interbank obligations spiked, the system froze—and only a deus ex machina could restore certainty. That deus had a name—lender of last resort—but the profession second-guessed it. And still has not reinternalized it, as Dan Davies writes today:
Dan Davies: are we having fear yet? <https://backofmind.substack.com/p/are-we-having-fear-yet>: ‘The Great Financial Crisis [of 2008]…. The overall economic system… [afterwards] was no longer able to perform a vital function of balancing present consumption and investment for the future…. Economics ought to regard this as more of a puzzle than it does [that] the financial crisis, which caused practically zero physical destruction of productive capability, left scarring and after-effects for more than a decade, while the COVID-19 pandemic, which killed millions and left lots of buildings unusable, was all reversed within a couple of years, with a fairly trivial inflation by past standards as the worst economic consequence…
For, of course, he then gives the answer:
Dan Davies: are we having fear yet? <https://backofmind.substack.com/p/are-we-having-fear-yet>: ‘The actual reason… the Global[1] Financial Crisis had such bad long-term effects and the pandemic didn’t is that one… was accompanied by a deluge of public sector money and private sector loan forbearance… precisely because the previous experience had been so bad; flooding the zone with cash made sure that it wasn’t overwhelmed with the flashing red lights of “BORROWER CAN’T MEET CASH CALL”. It would be nice to know that this is now the standard operating practice for similar crises. But I don’t think we do know that, and this is worrying…
But the thing is: This was not a lesson that should have had to have been re-learned after 2008.
Why not? Because it was a lesson that had already been well-learned long before, by 1873, when Walter Bagehot published his Lombard Street. The message was settled and clear. In a financial crisis, to deal with it, you need a central back to:
lend freely,
at a penalty rate,
on collateral that is good in normal times.
So why did economics as a profession not know this 150 year-old wisdom? And why has it still not internalized it properly? That is a hard question to which I—still—do not have a very good answer. But let me endorse Dan Davies’s Call to Action. And let me set out some disorganized and largely repetitive musings.