The Economy really is strong says Casey Mulligan

A friend of mine from the University of Chicago has this piece in last Friday's New York Times.

There are two faulty assumptions here. First, saving America’s banks won’t save the economy. And second, the economy doesn’t really need saving. It’s stronger than we think.

Bear with me. I know that most everyone has been saying for a couple of weeks that something has to be done; a banking crisis could quickly become a wider crisis, pulling the rest of us down. For this reason, the Wall Street bailout is supposed to be better than no plan at all.

Too bad this line of thinking is seriously flawed. The non-financial sectors of our economy will not suffer much from even a prolonged banking crisis, because the general economic importance of banks has been highly exaggerated.

Although banks perform an essential economic function — bringing together investors and savers — they are not the only institutions that can do this. Pension funds, university endowments, venture capitalists and corporations all bring money to new investment projects without banks playing any essential role. The average corporation gets about a quarter of its investment funds from the profits it has after paying dividends — and could double or even triple that amount by cutting its dividend, if necessary.

What’s more, it’s not as if banking services are about to vanish. When a bank or a group of banks go under, the economywide demand for their services creates a strong profit motive for new banks to enter the marketplace and for existing banks to expand their operations. (Bank of America and J. P. Morgan Chase are already doing this.)

It’s important to keep in mind, too, that the financial sector has had a long history of fluctuating without any correlated fluctuations in the rest of the economy. The stock market crashed in 1987 — in 1929 proportions — but there was no decade-long Depression that followed. Economic research has repeatedly demonstrated that financial-sector gyrations like these are hardly connected to non-financial sector performance. Studies have shown that economic growth cannot be forecast by the expected rates of return on government bonds, stocks or savings deposits. . . .

Since World War II, the marginal product of capital, after taxes, has averaged 7 percent to 8 percent per year. (In other words, each dollar of capital invested in the economy earns, on average, 7 cents to 8 cents annually.) And what happened during 2007 and the first half of 2008, when the financial markets were already spooked by oil price spikes and housing price crashes? The marginal product was more than 10 percent per year, far above the historical average. The third-quarter earnings reports from some companies already suggest that America’s non-financial companies are still making plenty of money. . . .

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Anonymous Anonymous said...

Hi John,

Casey seems to confirm what I was beginning to suspect: Too much of what Wall Street does is economically irrelevant. Does the world really need trillions of dollars of credit default swaps? Probably not.

Personally I pulled all of my retirement savings out the stock market from a large Wall Street firm last March. I won't do direct business with any Wall Street companies ever again.

10/13/2008 9:23 AM  
Anonymous Brent Crude said...

One of the first columns that looks like sense!

The free market has a mechanism for dealing with foolish bankers. Adam Smith's wealth of Nations had a very good section covering how 18th century scottish banks dealt with their bad customers:

Forced them to repay, which the customers did by taking out loans with a new bank which promptly went bust....

The fools lost their money and the rest of the economy carried on nicely.

I suspect the same would have been true today (if the politicians had the sense to leave well alone).


10/13/2008 3:52 PM  

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