Sub-Prime Economic Theory

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.

Some on the left, motivated in part by revulsion against financial types who are thought to reap unjustified incomes, have joined forces with conventional economists, whose almost religious belief in their models has blinded them to the harm their dubious economic theory can do to the real economy and the interests of ordinary people. No bailouts can mean no college for the kids – or, for many, no house.