Sub-Prime Economic Theory

The US Federal Reserve's recent interest-rate cut suggests that it recognizes the inability of conventional economic theory to account for, much less address, the current turmoil in financial markets. But that is a lesson that the European Central Bank appears not to have learned.

The insistence that those responsible for today’s financial crisis pay a price lest they repeat their mistakes – the so called moral hazard argument – recalls the great American orator William Jennings Bryan’s immortal “cross of gold” speech: “You shall not press down upon the brow of labor a crown of thorns. You shall not crucify mankind upon a cross of gold.” In other words, ordinary people should not be made to suffer for the foibles of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences – colorfully called a “reduced appetite for risk” – is the key reason behind the current sub-prime mortgage and financial crisis. To avoid future increases in this appetite, policymakers and pundits have focused on the so-called “moral hazard problem”: the “bad guys” must pay for their mistakes, lest they make them again.

One would have expected the modern-day William Jennings Bryan to be warning central bankers not to crucify mankind on a “cross of moral hazard and no-bailouts.” But, surprisingly, the opposite is occurring.

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