Re: good question Credit Default Swaps

[David Farber <dave () farber net>]

________________________________________
From: gruntled () gmail com [gruntled () gmail com] On Behalf Of Dave Wilson [dave () wilson net]
Sent: Friday, April 04, 2008 3:00 AM
To: David Farber
Cc: ip
Subject: Re: [IP] Re: good question Credit Default Swaps

Mr.  Brown asked:
"Why is it we don't hear about possible scenarios, like what happens if the investment banks can't raise the capital 
they need and are allowed to fail? "

Again, let me emphasize that I'm speaking solely for myself...

Well, the standard scenario goes like this: A classic economic monetarist would look at the Great Depression and say it 
was caused by a massive series of bank failures, which led to the collapse of the money supply, which led to an 
enormous contraction of economic activity, which led to horrible deflation (so your wages decline by, say 25 percent, 
and the real value of any debt you might have goes up about the same amount) and a quarter of the population 
unemployed; unemployment remained above 20 percent for the next *two years*. So, think about that: One in five men 
(nearly all jobs were held by men at that point) were out of work for three years. (As an aside, do you think we'd be 
able to extend unemployment benefits to 20 percent of  the population for three years?) I don't know any nice way to 
say this, so let me just lay it on the line: During the Great Depression, people were eating garbage, when they could 
find garbage.

And this pain was not limited to "bad" people, like the goofballs who'd engaged in ludicrous speculative ventures 
(*cough* negative amortization adjustable rate mortgages *cough*); oh no, *everybody* carried the weight of the Great 
Depression for the next decade. One argument made today against the Bear Sterns bailout is that it "rewards" bad 
behavior, that we should just let those jerks lose their jobs and their stock options. That would be awesome, but the 
problem is if Bear Sterns simply ceased to be, it would suggest that not only is the banking industry not capable of 
accurately assessing its financial health in a way that lets investors make valid choices, but that the government is 
prepared to let them fail.

I can hear you saying, "So let them fail! That's how its supposed to work." And yeah, that is how its supposed to work. 
But we tried that in the Thirties, and it was a freakin' disaster. Mr. Bernanke, the
Chairman of the Federal Reserve, is widely considered one of the world's foremost experts on the Great Depression, and 
I'm guessing he occasionally wakes up screaming these days.  In my opinon, the only thing he can do is keep trying to 
do what he's doing; anything less risks an unprecedented decline.

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