BERKELEY – Perhaps the best way to view a financial crisis is to look at it as a collapse in the risk tolerance of investors in private financial markets. Maybe the collapse stems from lousy internal controls in financial firms that, swaddled by implicit government guarantees, lavish their employees with enormous rewards for risky behavior. Or perhaps a long run of good fortune has left the financial market dominated by cockeyed optimists, who have finally figured that out. Or perhaps it stems simply from unreasoning panic.
Whatever the cause, when the risk tolerance of the market crashes, so do prices of risky financial assets. Everybody knows that there are immense unrealized losses in financial assets, but no one is sure that they know where those losses are. To buy – or even to hold – risky assets in such a situation is a recipe for financial disaster. So is buying or holding equity in firms that may be holding risky assets, regardless of how “safe” a firm’s stock was previously thought to be.
This crash in prices of risky financial assets would not overly concern the rest of us were it not for the havoc that it has wrought on the price system, which is sending a peculiar message to the real economy. The price system is saying: shut down risky production activities and don’t undertake any new activities that might be risky.
But there aren’t enough safe, secure, and sound enterprises to absorb all the workers laid off from risky enterprises. And if the decline in nominal wages signals that there is an excess supply of labor, matters only get worse. General deflation eliminates the capital of yet more financial intermediaries, and makes risky an even larger share of assets that had previously been regarded as safe.