There are two dimensions to the crisis — immediate crisis managment and long-term systemic reform.
On the first, both stock market and credit market responses to the seemingly endless string of “fixes” have been uniformly negative. Why? Because the leadership of the Treasury and Fed appeared panicked in warning of immense danger if something is not done immediately. But then when given the authority and money to act, the US Treasury does not act. “We’ll be ready in a few weeks.” Hardly reassuring. Were they incapable of forward planning? In the meantime, the original scare talk coming from Washington has made investors predisposed to believe the worst and nothing has happened to alleviate that concern. Lesson: Don’t say the sky is falling without acquiring a sturdy umbrella — and then opening it.
The second is the important issue of what happens after the crisis simmers down, which it eventually will. There are two diametrically opposite points of view, call them the Greenspan doctrine and the Volcker view. The Greenspan doctrine is that free markets overshoot and there is nothing anybody can do about that. But the good that they do during booms in creating new businesses, houses, etc. outweighs the damage done in the crashes. So don’t re-regulate the financial system.
The Volcker view, as nicely articulated in today’s WSJ, reaches an entirely different judgment. The crisis was man-made, based on reckless risk-taking by the originators of bad debt, and a mix of laziness and purposeful neglect by the buyers of that now toxic paper, conflicted ratings agencies, together with weak and unimaginative financial supervisors (admittedly often constrained by willing accomplices to the whole sordid process in the Congress). So man-made improvements to the financial system can go a long way to preventing another catastrophy.
Foreign official institutions and private investors alike are watching us closely. They are not sure that the US knows what it is doing in dealing with the crisis (example: the Fed knows full well that ratings agencies are a weak link in the system, but how do they propose to condition their radical new scheme to buy commercial paper to unfreeze that market? by credit ratings! As the man said, you can’t make this stuff up.) But the US has shown itself willing to borrow good ideas from others.(Unfortunately, not expeditiously: case in point, the term auction facility came maybe six months after the ECB was successfully doing almost exactly the same thing.)
Of lasting importance, of course, is what we do to put in place a better financial supervisory and regulatory system. The one we have now is broken beyond repair. It is too narrowly legalistic, too nit-picking (ask any commercial bank COO and you’ll get an earful) but misses the big picture, the real risks to the system that are being created. The way forward better be an improvement or our ability to attract foreign capital without onerous conditions will be gravely harmed.