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March 21, 2008
The crucial policy question is whether the Federal Reserve and other policy officials can prevent the scenario of a systemic financial crisis. The Anglo-Saxon financial system is in a severe crisis, of that there is no doubt. Reforming this system is necessary to restore confidence in the financial system and to reduce the risks of boom and busts in asset prices and credit that are becoming increasingly self-destructive.
Steve Bell
Nouriel Roubini reckons not but he acknowledges that after being behind the curve in its assessment of the economic and financial risks, the Federal Reserve now gets it and is worried about a serious systemic financial crisis.
For over a year the Fed assessment of the risks to the economy and to the financial markets was flatly wrong. The Fed argued that the housing “slump” would bottom out over a year ago; instead the housing recession got deeper and is nowhere near bottoming out; Bernanke argued repeatedly that the subprime problem would be a niche and contained problem; instead we have observed a severe liquidity and credit crunch that has spread to the entire financial system; the Fed argued that the housing recession would have no significant spillovers to the other sectors of the economy in spite of the importance of housing and in spite of the fact that housing is the main assets of most households; instead we are now observing an economy wide-recession. So to put it simply the Fed – as well as most macro analysts and forecasters - got it totally wrong in its assessment of the risks to the economy and to financial markets.
Sobering isn't it. Roubini says that the financial policy authorities are now fully aware of the risks of this scenario and they are starting to take some of the appropriate policy actions in the monetary and financial spheres.
However, he addsa realistic assessment of the risks in the real economy and in the financial system suggests that it will be very hard to avoid a severe economic recession and the financial fallout of such a recession.
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Financial market crashes do not emerge randomly, but follow booms. What fuels the boom are market estimates that risks are low. This optimism encourages imprudent lending, which eventually leads to the next crash. At which point some of those banks that helped stoke the boom take a dive.
Why not let them take a dive? Why should central banks bail out financiers from their own mess?