“Death of an Economic Paradigm” « naked capitalism

The financial market upheaval that started in May is a stark reminder that the conditions that produced the global financial crisis of 2007-08 have not been resolved. The sucking sound of deflation emanating from Europe and the creaking of bank balance sheets are calling into question the cheery assumption that patching up the financial system with baling wire and duct tape was a viable long-term plan.

With a large private sector debt overhang in most advanced economies, deflationary pressures are hard to forestall. It has become unacceptable politically to bail out banks, although monetary authorities such as the European Central Bank are creating SIV equivalents to do just that. Defaults look inevitable on a number of fronts, from homeowners in the US who are increasingly willing to abandon their mortgages, to the riskiness of not just Hungary, but other Eastern European borrowers as well (German investors have long expected serious trouble in Austria, whose banks were gateway lenders to Eastern Europe).

But why was the opportunity to restructure debts and revamp the financial system missed? In early 2009, the banking industry was on the ropes. Both the stock and the credit default swaps markets indicated that many of the big players were at serious risk of failure. But rather than bring vested banking interests to heel, the Obama administration and its counterparts in the UK and the European Union instead chose to reconstitute, as much as possible, the same industry whose reckless pursuit of profit had thrown the world economy off the cliff.