While testifying before the House Oversight Committee last week, Alan Greenspan said,
The economic crisis has revealed a flaw in the model that I perceived as the critical functioning structure that defines how the world works Those of us who have looked to the self interest of lending institutions to protect shareholder equity, myself especially, are in a state of shock and disbelief.
The recent crisis did reveal very clearly about one aspect of how the world works. There are in essence two economies: the real economy, where real goods and services are produced and consumed,
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I believe this dichotomy needs some explaining.
While the invisible hand of laissez faire does a pretty good job at keeping things in check in the real economy, it fails when applied to the financial economy. The free market relies on the mechanism of orderly discovery of equilibrium prices. In the speculative financial markets,
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When there are not enough shoes being produced in a real free market, for example, shoe prices go up, and the market adjusts by selling more shoes, causing shoe prices to come back down,
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While the real economy anchors on physical goods and services, the financial economy anchors on confidence of its participants. In this confidence game,
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Examples of self perpetuating cycles are everywhere in the financial world. Bubbles are caused by people buying assets that rose in price, causing the asset prices to rise even further. The richer you are,
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This is not a new idea. The lack of a stable equilibrium in the financial markets has previously been described in George Soros The Theory of Reflexivity. Even the late economist John Maynard Keynes knew that the spirit of market participants is unpredictable, and the government will often need to step in to prevent the economy from swinging,
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But let not give up on capitalism yet. Recent hiccup notwithstanding, the trend towards freer and more global markets has coincided with improvements in our overall standard of living,
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This credit crisis has emboldened certain observers into declaring doesn work We already hear about politicians all over the world taking advantage of this opportunity to enact regulations over many areas of the economy. There is now significant risk that governments of many nations are on the trajectory towards a more socialistic/protectionistic stance, destroying the climate of globalization and capitalistic experimentation that has served us so well throughout history.
It is not my intention to trivialize the recent credit crisis. The crash in the Dow Jones Industrial Average,
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