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Worth the Risk
September 2009

Is it now too late to restrain the regulators? They undoubtedly see themselves as following the path of righteousness and have wide support in their attack on wicked bankers. When Dominic Strauss-Kahn, the managing director of the International Monetary Fund, proclaims that "speedy recovery" depends "on cleansing banks' balance sheets of toxic assets", he is listened to with respect. When he claims that "the primary objective must be to get the stalled machinery of the financial sector moving again", he can expect to be praised in the newspapers. 

But — despite Strauss-Kahn's appeal to 122 country studies — he is incorrect. The message of all financial crises is that policy-makers' priority must be to stop the quantity of money falling and to get it rising again. That is what matters above all. If Strauss-Kahn intends by the "cleansing of bank balance sheets" that banks must shed assets and shrink their balance sheets, he is proposing to lower the quantity of money and aggravate the recession. 

In the early 1930s, the US Treasury Secretary, Andrew Mellon, gave his advice on how to deal with the economy. "Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate." The doctrine of liquidationism was exactly the wrong answer. If one person spent less, that was lower income for someone else. If one company repaid its bank loan rather than invested in new equipment, that was less money in the bank balance of the equipment supplier. The essence of liquidationism was the retreat to extreme safety, but its wider result was a deflationary disaster. 

The pressure on banks to "de-risk" and to "de-leverage" is the modern version of liquidationism. Of course, banks must over time recognise their mistakes and take losses. But the right moment to announce losses is when the recovery is well established and banks are making good profits on new business. It would be a tragedy if the paradox of excess regulation — that the search for safety at the level of each particular bank can cut the money supply and aggravate demand weakness in the whole economy — leads to a continuation of the global recession in 2010.

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