September 24, 2008

The headlines tell the story as recent days have seen the American economy and its financial system buffeted by seismic failures and the virtual disappearance of major investment banks.  The debate raging in Washington these days concerns the form and extent of government intervention that will be required in order to restore stability to the financial markets.

Comparisons to the Great Depression are inevitable, but today's crisis bears little resemblance to the total economic collapse of the late 1920s.  Capitalism is not in crisis and the fundamentals of the American economy remain strong.  When President Franklin D. Roosevelt took office in 1933, the nation faced a genuine crisis and economic collapse.  For the most part, the banks were closed and the nation was out of business.

Nothing like that is happening now, but the financial system is clearly in need of reform and realism.  The fundamentals of the economy remain intact.  These include American innovation, a dedicated labor force, strong consumer demand, vast natural resources, and unlimited intellectual capital.

More than anything else, this crisis has to do with what happens when the markets come to term with excessive valuations.  Put bluntly, wildly inflated valuations led to risky financial adventures and worse.  The sub-prime mortgage collapse came as more realistic real estate valuations forced market corrections.  The vast global financial system has accepted the inflated valuations as real and traded in the risky mortgages as if the game would go on forever.  This was a fool's errand.

There were other causes of the current distress in the markets and other forces at work within the economy at large. The slide of the dollar and the rising price of oil both played a part, as did more fundamental shifts having to do with a globalized economy and the continuing shift toward a knowledge-based economy in a technological age.

Is this all about greed?  Yes and no.  In the movie "Wall Street," the character Gordon Gekko famously declares that "greed is good."  But is the economy really driven by greed?

This question requires a return to what we might call "Economics 101."  No one has explained basic economics as well as Adam Smith did in his 1776 classic, The Wealth of Nations.  As the great Scottish thinker explained, an economy is based upon the transfer of goods and services from one individual to another.  Each partner in the transaction must believe that this transfer is in his or her own best interest or the transfer is not voluntary.  Both parties seek to gain something from the transfer.  Since no one person can meet all of his or her own needs alone, a vast economic system quickly takes shape.  Individuals trade goods and services through the exchange of currency or another agreed-upon form of value.