Irrational versus Rational Financial Panics

There is  a big difference between a crisis of liquiditya nd solvency, as Pual Krugman popintso ut in today’s NY Times.  Liquidity is a problem of access to cash in a defined time frame.  Solvency is a problem of not having value (assets).  The problem with the current housing blues (sub prime weakness et al) is one of solvency, not liquidity.   The big financial institutions simply made a lot of bad loans.  Until those are uncovered and dealt with, fundamental confidence will not return.  hence, investors, worried that market signals about which loans and institutions are high irsk are not clear at all, are quite rationally paniced.  This is quite different from the “irrational” bubbles I discussed with my students like the 17th century tulip bubble or the 1990s dot-con bubble.  In those cases, values were bid up over hard to specify assets because decision makers paid attention to relevant others.

When will things be better?   Can the Fed and Treasury make things right? Here is what Krugman prognosticates:

After the Money’s Gone – New York Times
Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.

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Filed under Banking, Government, macroeconomics, Political Economy

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