Leijonhufvud offers a view of the role of finance in macroeconomics, particularly in producing deep recessions.
But financial systems can become fragile. When this is the case, one default can trigger an avalanche of defaults. Most avalanches are small and self-limiting. But in extreme cases they can take down very large portions of the web of contracts. A major collapse of the web will be associated with a breakdown in the economic organization of a country and widespread unemployment of labor and other resources. But it is more serious than that. A default avalanche leaves a myriad of broken promises in its wake. Social relations are disrupted by distrust and recriminations all around. . .
A financial crash reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again. Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. If we had done so this time, it would simply have led us into another Great Depression.
What I believe he is arguing is that choices have to be made concerning who gets paid and who does not. You cannot expect justice to be fair–you just want it to be swift.
I like the “web of contracts” description of the role of the financial sector. It is an idea worth coming back to. It ties in both with Leijonhufvud’s classic work on the “corridors” interpretation of Keynes (see my discussion, but also explore other sources) as well as with PSST and recalculation.
It isnt isn’t a commandment that bankruptcies courts have to be slow fail. In fact how does he know the ad hoc bailouts aren’t what made it as bad as it was. Basically the same question we’ve had for 6 years.
It is not the job of bankruptcy courts to work out the eventual incidence. It is the job of bankruptcy courts to work out the immediate incidence based on long-standing and well-known rules. That they do this as fast as possible with as little political input as possible is a feature, not a bug. The eventual incidence will be determined by markets that recognize the rules and incorporate the rulings.
Arnold:
I’ve read the Leijonhufvud “Monetary Muddles” paper a couple of times, and parts of it are interesting and even thought provoking. But this passage in particular is neither interesting or thought provoking. It is at this particular point in his paper that he resorts to, and relies upon, a variety of incorrect myths, metaphors and hyperbole to justify precisely incorrect and unjustified conclusions – to wit …
“Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. If we had done so this time, it would simply have led us into another Great Depression.”
and …
“But the questions that demand an answer are of the utmost polit-
ical difficulty: Who must be paid? Who does not get paid? Who must
(in effect) pay for someone else’s debt? Who gets away without
paying?” [emphasis mine]
He is precisely wrong. It is precisely when contractual obligations begin to fail – and especially when such failures ostensibly begin to result in cascading contractual failure – that rule of law, and NOT “political” or ad hoc remedies, must be applied.
You stated, “You cannot expect justice to be fair–you just want it to be swift.”.
I never expect “fair” and I actually don’t want “swiftness”. I expect and want RULE OF LAW. And it should have been applied in 2008, rather than the ad hoc, arbitrary, “swift” – and costly – remedies that were actually applied in 2008. The entire “bailout” exercise of 2008 was designed specifically and intentionally to bypass and preclude application of the rule of law. And it was that that was the most disgusting and damaging aspect of the entire incident.
Leijonhufvud asserts that, “had we [relied upon bankruptcy courts and rule of law in 2008], it simply would have led us into another Great Depression.” Why? Because he says so? Because the political principals of the time say so?
I have argued and will continue to argue that a substantial element of economic damage that occurred in 2008 and subsequent was a result of the obvious demonstrated willingness of Government to completely subvert its own legal system. The message was made clear to the entire economy – The legal system, laws, and courts can’t be relied upon when things “really really really” go bad.
So all one has to do to completely bypass the U.S. legal system – with full cooperation from Government – is to convince someone in “authority” that things are “really really really” bad, or “really really really really really” bad – or whatever. And of course use metaphor and hyperbole – “crisis”, “catastrophe”, “nuclear meltdown”, “web” (of lies, deceit, contracts, whatever), “avalanche”, “crash”, and all the rest of the drivel that was being spouted at the time (and evidently continues) in order to subvert the rule of law.
Leijonhufvud is correct in one respect – most economists “missed the boat” (my own metaphor) with regard to either predicting the onset of the financial crisis, or to understanding the aftermath. I would suggest that, as long as “economists” continue to rely on myth, metaphor and hyperbole to describe and understand the phenomena, they will continue to “miss the boat”.