Humpty Dumpty Economics

We must, in one way or another, pay the costs of the excesses we have indulged in over the past decades, and any form of “emergency medicine” aimed to avoid this harsh reality will simply delay (and magnify) the eventual reckoning.

If we were smart, we would have learned a lesson from Japan, which experienced a spectacular crash of real estate and financial assets beginning in the early-90s. By failing to acknowledge the extent of their problems and trying to prop up the eroded foundations of their financial system, the Japanese authorities only managed to prolong the suffering, producing a period of economic stagnation that stretched out for over a decade.

We now face the same daunting choice – i.e. come to terms with the realities of a dangerously overextended financial system and tolerate a period of economic hardship, or continue to administer emergency measures, which will solve nothing but only prolong and magnify the problems. Unfortunately, it seems we are opting for the latter.

The most recent batch of emergency measures includes a three-pronged attack – i.e. rate cuts by central banks, a mortgage bailout scheme, and emergency injections of liquidity into the financial system. None of these measures are likely to have a significant impact in terms of long-term healing of the financial system, and all three present significant risks of causing even bigger problems.

Let’s consider the recent proposal by the US Treasury to freeze rates on adjustable-rate mortgages. As we all know, millions of Americans face the prospect of losing their homes as a result of “exploding mortgages”. It seems to make sense that one way of solving the problem is to defuse the ticking bomb by preventing upward adjustments in mortgage interest rates. However, this logic is superficial and fundamentally flawed.