Modern economics is now bankrupt

What we are witnessing, in the broadest sense, is the bankruptcy of modern economics. Its conceit has been that we had solved the problem of stability. Oh, there would be periodic recessions, but the prospects of a major economic collapse were negligible because we knew how the system worked and could take precautionary steps to prevent it.

What's been so unsettling about the present crisis is that it has not conformed to the standard model of business cycles and has not submitted to familiar textbook solutions. A hallmark of the crisis has been the stark contrast between the “real economy” of production and jobs and the tumultuous financial markets of stocks, bonds, banks, money funds and the like.

Even with the 60 percent drop in housing construction, the real economy has so far suffered only modest setbacks. Meanwhile, financial markets verge on hysteria. The question is whether this hysteria will drive the real economy into a deep recession or worse – and what we can do to prevent that.

The word that best epitomizes mainstream “macroeconomics” (the study of the entire economy, not individual markets) is demand. If weak demand left the economy in a slump, government could rectify the situation by stimulating more demand through tax cuts, higher spending or lower interest rates. If excess demand created inflation, government could suppress it by cutting demand through more taxes, less spending or higher interest rates.

But this crisis originated in frightened financial markets. Massive losses on mortgage-related securities caused some financial institutions to fail. As fear spread, financial institutions grew wary of dealing with each other because no one knew who was solvent and who wasn't.

To Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, this financial breakdown now threatens the real economy. Credit markets were freezing, Paulson and Bernanke decided. Panicky investors were shifting from commercial paper to Treasury bills; banks weren't lending to each other. Consumers and firms wouldn't get essential credit.

If you reject that conclusion, then the whole crisis has been a contrived farce. Some economists do; they note that downturns always involve losses and disruptions. This one isn't so different. But many economists agree with Paulson and Bernanke. “If we can't calm down short-term credit markets, we're looking at a pretty severe recession,” says Michael Mussa of the Peterson Institute. “If businesses can't roll over their short-term debt, (they) ask where can we cut back” – firing workers, reducing spending – “to avoid bankruptcy.”

Of course, economists recognized that the Federal Reserve should act as a “lender of last resort” and that permitting two-fifths of banks to fail in the 1930s aggravated the Depression. But the creation in 1933 of deposit insurance (now up to $100,000) was thought to prevent most bank runs, and the “lender of last resort” role never anticipated a worldwide financial system that mediated credit not just through banks but also through hedge funds, private equity funds, investment banks and other channels.

Paulson's plan to buy up to $700 billion of impaired securities is wildly unpopular. It may not work and raises many problems. If the government pays too little for the securities, financial failures may mount; if it pays too much, it may create windfall profits for some investors and losses for taxpayers. But Paulson's plan has better prospects to restore confidence by removing suspect securities from balance sheets than suggested alternatives.

The economy will get worse. The harder question is whether financial turmoil heralds an era of instability. Our leaders are making up their responses from day to day because old ideas of how the economy works have failed them. These ideas were not necessarily wrong; but they're grievously inadequate.