Financial Crisis and Public Policy

This Policy Analysis explains the antecedents of the current global financial crisis and critically examines the reasoning behind the U.S. Treasury and Federal Reserve’s actions to prop up the financial sector. It argues that recovery from the financial crisis is likely to be slow with or without the government’s bailout actions.
An oil price spike and a wealth shock in housing initiated the financial crisis. Declines in stock values are intensifying that shock, threatening to deepen the current recession as U.S. consumers and investors cut their expenditures. An offsetting wealth injection from additional risk-bearing investors could initiate a quicker recovery. Thus, supporters of government intervention justify the bailout’s debt-financed fund injections — in essence, they want to compel future taxpayers to join the group of today’s riskbearing investors.
However, the bailout is poorly designed and its implementation appears panicky — marked by a knee-jerk trial-and-error process that may have heightened market uncertainty. Worse, current interventions in market processes and institutions could become permanent, to the probable detriment of the nation’s long-term economic prospects. With or without the bailout, the ongoing recession is likely to be deep and long.

Jagadeesh Gokhale

The Cato Institute

March 23, 2009

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