The real solution to the financial crisis: recession
Stubborn efforts to avoid it have stoked the crisis.
The much-maligned bailout appears set to become law. Members of Congress suggest they'll hold their noses but vote for it anyway. Their reasoning? Something must be done.
The premise is that doing nothing will hasten recession. And recession is unacceptable.
But that kind of thinking is a big reason we're now on the verge of a financial meltdown. By taking a zero-tolerance policy toward recession, Washington has dangerously juiced the economy with monetary steroids for more than a decade.
The painful truth is that recession may be precisely what's needed to restore economic health. Yet the bailout attempts to avoid this crucial reckoning – which may make things worse.
It may seem odd that avoiding slowdowns could have side effects. Recessions, after all, cause real damage: job losses, higher levels of business failures, and falling tax receipts.
However, just as seemingly healthy measures, such as taking vitamins, can cause damage if done to excess, so did the Greenspan-era Federal Reserve take recession avoidance too far. It helped feed the excessive borrowing that is the root of our current crisis.
In the wake of the dot-com crash, the Fed went way beyond past fixes and lowered the funds rate to 1.25 percent for nearly eight months, then an extraordinary 1 percent for a full year.
At such low levels, consumers who save lose; they are better off spending or borrowing. And they did both. Private debt as a ratio to Gross Domestic Product skyrocketed some 50 percent in five years. Similarly, the savings rate plummeted to zero.
But the Fed was overly permissive even earlier. By 2001, the "Greenspan put," the idea that the Fed would be quick to cut rates to prevent a stock market decline, was part of the vernacular and investor conditioning.