What went wrong with the economy?

On Wednesday David Leonhardt posed the question, here is part of my answer:

To understand the depths of the current crisis, let’s go back to an
apparently unrelated episode in economic thought: the socialist
calculation debate. Starting in the 1920s, Ludwig von Mises, the leader
of the so-called Austrian School of Economics, charged that socialism
was unable to engage in rational economic calculation. Without market
prices, he reasoned, no one knows how much economic resources are

The subsequent poor performance of planned economies
bore out his point…The irony is that the supercharged
capital markets of the American economy are now – at least temporarily
– in a somewhat comparable position. Starting in August, many asset
markets lost their liquidity, as trading in many kinds of junk bonds,
mortgage-backed securities and auction-rate securities has virtually

Market prices have been drained of their informational
value and thus don’t much reflect the “wisdom of crowds,” as they would
under normal circumstances. Investors are instead flocking to the
safest of assets, like Treasury bills.

The absence of trading
is a big problem. Financial institutions have been stuck holding
illiquid assets, whose value cannot be easily determined. Who wants to
lend to the institutions holding them? No wonder there is a credit
crisis and a general attitude of wait and see.

And here is another problem, namely the relationship between Mises’s argument and the degree of leverage.  When leverage is high the needs for exact calculation are much greater:

This gridlock is especially harmful because leverage is so high, and
financial institutions are so interconnected through swaps and loans.
Institutions that rely so heavily on debt are precarious and need
up-to-date information about valuations. When they don’t have it,
markets freeze up. This is what has taken policymakers by surprise and
turned a real estate crash into a much bigger financial problem.

Do read the whole thing; I also consider why price declines don’t necessarily restore asset liquidity.


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