On the fallacies of the free market

The economy is in tatters and the markets are crashing! Billions of dollars of wealth (notional I agree) wiped out! The mortgage crisis, bad credit blah blah, greedy investment bankers...history repeats itself. What next? As most of you must have read, congress has voted against the proposed bailout package which could have potentially buoyed the market. As expected investors reacted by hammering the market. The question remains, was it the best decision to block the bailout package?

The credit crisis in recent times has made life tough for the average citizen. Banks are tougher on lending these days and even individuals are feeling the crunch with credit card limits being downgraded as we speak. The economy has slowed down considerably and the labor market is tight. In this backdrop, with lesser jobs and an uncertain future, people stop spending and start saving. When people start saving more the resultant lack of consumer spending hurts producers. When producers start feeling the pinch, they start to cut down on their costs and more layoffs occur. Thus the entire process spins out of control and leads to a depression.

What was the proposed solution to prevent the economy from tanking? Neutralize the credit squeeze in the market by bailing out banks. The government's plan on bailing out banks by removing bad assets might work, because it helps the banks balance sheet to walk out of the red zone. With the bad assets gone, banks are more healthy and can lend with more comfort thus inducing investment which in turn should lead to higher consumer spending. In sum, the idea is to kick start the economy by neutralizing the credit squeeze. In return, when markets bounce back the assets can slowly be removed from the books and the government does not really stand to lose.

Why was the plan rejected? Reports suggest that the citizens are unhappy with the plan, mainly because they think investment bankers were greedy and deserve to be in their current predicament. With elections nearing, it is a risky proposition from a political perspective to side an unpopular vote. Hence, it is but understandable that the vote went against the plan. The question remains: How informed is this opinion?

Agreed it might be a little late in the day to prevent near term depression in the economy, but the bigger question facing us today is how long will this depression last. There are striking similarities between what happened in Japan in the early 90's and the current situation in the US. In the Japanese case the economy tanked and stayed there for nearly 10 years. Will we see a similar recession here? While the opinion of the people is important, is it informed enough? Do they realize that their opposition will come back to bite them over the next few months? Only time will tell!