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>> 159 6 The Crisis in Crisis Management Dismissing financial crisis on the grounds that bubbles and bust cannot take place because that would imply irrationality is to ignore a condition for the sake of a theory. Charles P. Kindleberger (2000)1 The history of capitalism proves that financial crises can be eliminated only with superior legal and regulatory infrastructure, if then. The MIT economist Charles Kindleberger, in his classic Manias, Panics and Crashes, shows that aside from a thirty-year period of stability, from 1945 through 1975, “speculative excess,” such as manias or panics, is “if not inevitable, at least historically common.”2 Professor Hyman Minsky takes Kindleberger’s argument a step further: “turbulence—especially financial instability—is normal in a capitalist economy.” Minsky’s key insight relates to the centrality of the financial sector to growth and the optimism engendered by stability and growth. Speculative finance will naturally follow stability, especially in a laissez-faire financial system. Sooner or later the system will gorge on risk. Manias, crashes, and bubbles are therefore inherent to capitalism.3 According to Minsky, capitalism is rigged toward instability; even periods of stability breed excessive risk. Monetary policy fails to resolve this essential challenge. The Nobel laureate Robert Lucas famously declared severe economic disruptions an historic 160 > 161 and tomorrows.” Yesterday’s profits invariably lead to an underpricing of risk today, with a consequent crash tomorrow when risk becomes an adverse reality .11 In short, the Minsky thesis essentially predicted the subprime debacle. Regulators and policymakers should therefore assume that markets tend toward instability, as history certainly proves this central point. Government regulation must err on the side of caution as well as impose redundant systems to ensure the stability of the system. Since the date of Greenspan’s speech, the complexity of the global financial system has increased. Consequently , the need for ever more optimized legal frameworks to secure government ’s crisis management efforts is ever more compelling. This chapter articulates legal frameworks securing precisely these kinds of governmentsponsored stabilization efforts. In modern capitalistic societies, government must respond to financial crises and other economic disruptions or risk economic contractions and the wrath of voters. This implies massive government intervention into the economy . This reality means that law faces a challenge to organize government’s economic interventions through optimized legal and regulatory frameworks .12 Once again, this chapter demonstrates that excessive economic and political power corrupts sound policy in the absence of legal limits, at great expense to growth and stability and by extension to society generally. In terms of stabilization policies, government enjoys three channels of influence: monetary policy, fiscal policy, and firm bailouts. Monetary policy relies upon expansion of the money supply, usually through expanded bank credit, to stoke demand and quell economic downturns. Fiscal policy seeks to replace slack in demand with enhanced government spending. Bailouts involve the use of government resources to stop economic contagion and control systemic risk from the failure of large or interconnected firms. In the crisis of 2007–9, each of these stabilization instruments played a prominent role in the government’s response. Moreover, each of these instruments suffered from a suboptimal institutional structure as well as inappropriate political subversion. In what can only be termed an epic effort, the government deployed massive financial resources to stemming the downturn, particularly during the fall of 2008 and the spring of 2009. The government assumed potential obligations of $23 trillion and made massive outlays that continue through today and long into the future.13 The Federal Reserve extended more than $16 trillion in loans to save the entire global financial system.14 It also purchased $1.25 trillion in mortgage-backed securities from the financial sector to prop up real estate values.15 Furthermore, Congress provided $700 billion through the Troubled Asset Relief Program to recapitalize the 162 > 163 therefore act as a key “transmission belt” of monetary policy.24 If banks lend, then more money can be spent to support economic activity. The Federal Reserve can induce more borrowing through interest rate cuts. When interest rates fall, loan demand increases. The Federal Reserve maintains direct control of a bank’s cost of funds through its control of the Federal Funds rate. That rate governs the costs of loans made through shortterm interbank loans. The Federal Reserve also influences interest rates through its open market operations conducted through the Federal Open Market Committee. When it buys government bonds, it injects reserves into the banking system, and buying bonds...

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