What can be done to prevent a disastrous collapse in credit in the first place?
Forbid force-fed credit
First and foremost the government should be prohibited from creating debt instruments, lending to banks, injecting liquidity into banks, setting interest rates, borrowing off the central bank, borrowing off the public, or any other activity that will affect credit markets.
So far as systemic risk is concerned, credit inflation is not prevented by prudential regulation. All that happens is the excess credit is channelled into the shadow banking sector, as happened with securitized lending in the boom that ended in 2008. If the shadow banking sector is then regulated, the flood of credit will simply be diverted elsewhere. Whether it be tulips, dot com shares or sub-prime mortgages, eventually it bursts out somewhere. Thus, prudential regulation is futile to prevent risky investments when the government issues excess credit. It will insulate the domestic banking sector from the contagion caused by a worldwide credit boom, but it will not help a credit-inflating nation.
Too big to fail
They tell us, that the public is better able to bear the loss than private men; which certainly is not true … but if it were so, are they therefore to take the ill bargains of all private men to themselves, and protect them in their good ones? Must every man who has suffered by playing the fool, or playing the knave, call upon the nation for reprisals? But … who shall repair the many bankrupts, the many creditors who have lost their debts, the many young ladies who have lost their fortunes, the mechanics and shopkeepers who have lost their business, spent their stocks, and yet have run in debt to subsist their families … must all these contribute at last, out of what remains, to repair the misfortunes of those who brought all these evils upon them?
—John Trenchard. Cato’s Letters No. 92, Against the petition of the South-Sea company, for a remittance of two millions of their debt to the public, Saturday, September 1, 1722.
Systemic risk increases markedly if the government indicates that it believes a company or industry is too important to be allowed to fail. Removing risk for investors in these industries only encourages irresponsible behavior as they chase high returns with no downside. Competitors are between a rock and a hard place, and, if they follow suit and make risky bets, they will be wiped out when the market turns. If they stay sane they will lose market share.
The correct thing to do is for the law to make it clear that no company or bank is too big to fail. Just as no public figure is too important to be charged with corruption, no company is immune from the need to be solvent. Indeed, sooner or later all companies make a big mistake or lose touch and get liquidated or are swallowed up by younger, leaner competitors; it is the natural order. The liquidation of unviable banks, insurers, and manufacturers will return stability to the market quicker than any other factor. Moreover, the collective memory of such blood lettings will encourage investors, and therefore management, to be more prudent and farsighted in the future.
There is no moral basis for taking from the innocent public to reward bad investment decisions or to prop up failed business structures. By allowing those who invest unwisely to absorb the losses and those who invested wisely to reap the rewards, responsibility for making investment decisions is moved into the hands of the competent, to the general benefit of all.
Guarding against contagion
It is a misnomer to call the sudden loss of confidence which precipitates market adjustments a ‘contagion.’ Use of that word suggests that the underlying cause is some contagious disease that spreads at the time of the bubble bursting. A better analogy is to consider a credit bubble like rotten trees in a forest. When one comes crashing down, the vibration may cause other rotten trees to do likewise, but the underlying cause of those other collapses was the rot, not the vibration. Their collapse was inevitable. Healthy trees are unaffected. Thus, the government should not try to stop or slow the forced liquidation of assets at depressed prices. Rather, it should positively encourage forced liquidations at depressed prices. Wealth is not thereby lost from the economy, because the intrinsic value of the underlying asset will not be destroyed. Rather, the asset will simply be transferred to wiser hands where it is likely to be employed more wisely, to the general benefit. This is because unwise superintendence of capital (as when Soviet bureaucrats controlled all the capital of Russia) causes economic stagnation that causes everyone to live in misery.
Regular mini-recessions are needed
Systemic risk increases when companies and individuals have not seen a contraction in credit for more than ten years. They tend to forget the bad times and start taking unwise risks. This occurs only when the government staves off mini-recessions through force-fed credit. In the absence of force-fed credit, smaller, more regular, adjustments occur. These are restricted to regions and industries and occur regularly, almost continuously. They act as a sophisticated autonomous regulator ensuring that investment, and thus direction of economic activity, is optimized.