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Home > Blogs > Ian Fraser > Propping up failures only prolongs recession

Propping up failures only prolongs recession

Finance Blogger: Ian Fraser Ian Fraser

Are governments too eager to sustain banks that would otherwise have gone bust and are they too keen to lend a hand to the casualties of recession, such as US car manufacturers? And in doing so, are they at risk of inflating asset price bubbles that could turn out to be every bit as dangerous as that which burst so spectacularly in 2008?

The way in which readers respond to this question will probably depend on their political leanings, as well as whether they subscribe to the Chicago or Keynesian schools of economics. Despite my recent meeting with the superb Keynesian Lord Robert Skidelsky—to which I intend to return in a subsequent blog post—I’d like to start by presenting the views of right-wingers whose faith in free markets persists despite the crisis.

To such people, the response to the crisis has been misguided and the politicians responsible have forgotten important lessons from the past, including that the process of “creative destruction” outlined by the Austrian economist Joseph Schumpeter in the 1940s has some virtues.

Their argument is that too much mollycoddling of institutions which would otherwise have gone bust is harmful in that it entrenches bad habits—and can also be deleterious to a nation’s long-term economic health. Citing the example of Japan in the 1990s, they say politicians who bail out everything that moves—however dysfunctional—are condemning their nations to “L”-shaped recessions which could go on for years.

Tom Clougherty, executive director of London-based think tank the Adam Smith Institute explains: “Recessions are a necessary remedial phase in the economic cycle in which the distortions that have built up during the boom years are unwound, bad investments are liquidated, and relative prices return to normal. In other words, recessions are a necessary step in preparing the ground for a return to economic success.

Writing in a blog on the Adam Smith Institute’s website, Clougherty added: “There is a real danger, however, that government will interfere with this process if their actions go beyond easing the pain of adjustment and instead represent an attempt to re-inflate the bubbles of the boom years while propping up failed business models.

“That is the recipe for economic stagnation, and most likely inflation too. It is also precisely what the current British government’s policies aim to do: bail out failed banks, prop up failed businesses, and pump enough money into the economy to restore the housing and financial asset bubbles, return bank lending to previous, unsustainable levels.”

There are strong parallels with the views expressed by Jim Rogers in his QFINANCE Viewpoint. Asked what lessons the developed economies can learn from the banking and financial crisis, Rogers said: “The lesson that they should learn is to let the market work. During the past 15 years, in the United States especially, they refused to allow the market do its work. Alan Greenspan swore every day that he believed in market forces but every time there was a problem, he over-rode the market.”

Rogers believes that the US government-orchestrated bailout of Long-Term Capital Management in 1998 sowed the seeds of the current crisis in that it persuaded incompetent financiers to think they were competent. Many went on to run institutions such as Bear Stearns and Lehman Brothers into the ground later on, according to Rogers.

The trouble is that after the US government decided to let Lehman meet its fate last September, the consequences were so dire, that such thinking fell out of fashion.

Tags: bailout , creative destruction , financial crisis , fiscal stimulus , Japan , recession
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