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US policy makers uncertain how to deal with another crash

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How will US policy makers respond to another crisis in financial markets? With global markets this week facing a triple whammy from Greek debts to Chinese belt-tightening to Obama’s bank reform plan, it is a fair question to ask.

Nobel prize-winning economist Professor Joseph Stiglitz is convinced that the US will need a second stimulus plan. This is to go down the road of Japan in the 1990s with one government bailout after another, and that did not work either for the stock market or the economy, although the Japanese economy continued to function and export strongly.

No clear consensus

However, his views are far from being a consensus, wrong or right. And that is surely the major problem in another crisis. The consensus, indeed rallying of national purpose, behind President Obama and his perhaps too successful bailout of Wall Street has broken down.

In fact, the president is endeavoring to champion the anti-Wall Street faction with his plans to get tough on the banks. But you cannot simultaneously expect a boom in bank lending to revive consumer spending and household wealth, and to tie the hands of the banks at the same time.

The banks are hardly blameless in all this but they are commercial institutions. When the government offered them almost free money they took it, and lent it back to the government at a profit. This is rebuilding bank balance sheets after the crisis, and their bonus pools.

The danger is that politicians are now guilty of believing their own propaganda about the quick and successful recovery from the financial crisis. The reality is far less solid than it appears, and cracking down on the banks too sharply will again produce the very type of crisis that the government has so recently avoided.

Chinese solution

Economists like Professor Stiglitz propose massive government spending to stimulate the moribund US economy, as in China. But that causes a gross misallocation of capital, an asset price spiral and only works if there is a follow through from the private sector. Essentially the public sector takes the resources of the nation, puts them in the wrong place and starves the private sector of credit.

Is that how the US will respond to another Wall Street Crash? If so it may not be very helpful at all, and it is understandable that the consensus in favor is diminishing, making the policy outlook even less certain.

Is not the truth that far too low interest rates for far too long produced asset prices that now have to correct to something more in line with the true cost of money? Keeping the cost of money low as a response will therefore make things worse not better. It can only delay the Day of Reckoning, not avoid it. Bring on the stock market correction.

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Written by Peter Cooper

January 25, 2010 at 8:17 am

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