Time to Put Finance Back in Its Cage

It's not that economies are too slow to appease markets. It's that the markets have too much power to destroy economies. Let's not forget -- this entire crisis was caused because markets mispriced risk.
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Last Wednesday, speaking at the Council on Foreign Relations, Treasury Secretary Tim Geithner had this to say about the deepening European crisis: "If you wait to move on these things and you let the market get ahead of you, then you increase the cost of the solutions." Geithner was referring to efforts by European leaders to shore up Europe's banking system and public finances, to regain the trust of money markets.

But what's really at work here? As financial markets pull money out of economies perceived to be weak, the cost of government borrowing goes up, rating agencies downgrade bonds, private investors pull put capital, and the whole cycle feeds on itself. Then governments and central banks need even more heroic measures to try to stem the tide, and they demand more budget austerity in return, deepening the crisis still further.

Europe was actually heading towards a modest recovery in late 2009. Growth was resuming and unemployment was coming down in most countries. Then the new Greek government elected that October reported that the Greek deficit was worse than previously reported; hedge funds began betting against Greek bonds; and then the run on sovereign debt spread to Portugal, Spain and now Italy, where interest costs on bonds keep rising and the European authorities keep playing catch-up.

It wasn't the Greek economy, accounting for about 2 percent of European GDP that deepened the crisis. It was the speculative response to the Greek situation.

Geithner's comment gets the real dynamics backwards. It's not that economies are too slow to appease markets. It's that the markets have too much power to destroy economies.

Let's not forget -- this entire crisis was caused because markets mispriced risk. That's a polite, bloodless way of saying that a bunch of overpaid wise guys bet the farm on the premise that housing prices could never fall, and created opaque securities that made a lot of insiders rich and duped the rest of the economy at a cost of several trillion dollars.

So if financial markets totally screwed up when they created collateralized debt obligations backed by sketchy mortgages and treated them like triple-A bonds, why do we think that the same financial markets are to be trusted when it comes to accurately pricing Greek or Italian or Spanish bonds?

Look at the recent experience of interest rates on these bonds, and they bounce all over the place. The true financial risk can't possibly change so much from week to week.

In the years after World War II, the debt overhang was huge, but Europe nonetheless achieved an impressive economic recovery. One major reason was that financial speculation was kept in its cage. The whole menagerie of derivatives that permit speculation against government debt hadn't been invented yet, and were precluded by the rules of the game. The economist Carmen Reinhart terms this era one of the "repression" of finance -- a term that sounds ominous but in fact is what allowed the postwar recovery to go forward and not to be destroyed by debt.

Alas, the word's commentators and political leaders are mostly arguing just the opposite: if markets are betting against Spain and Italy, the story goes, they must know something that we don't.

But what they mainly know is how to create self-fulfilling prophesies of economic destruction -- highly profitable to the speculators and ruinous to everyone else. A good dose of repression of financial speculation is just what we need today, whether through financial transaction taxes, regulations, capital controls, or governments intervening on the opposite side of speculative bets.

This crisis occurred because financial markets were allowed to run amok. Now the speculators have turned their fire on sovereign debt. If they are allowed to keep running wild, recession will turn into needless depression.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.

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