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Winds of creative destruction

The political reaction to the recent credit crisis has been in some ways predictable: Democrats (like Barney Frank in this FT editorial) have called for more regulation of rapacious, predatory lending markets that thrive on the ignorance or irrationality of their victims, while conservatives defend the ability of markets to sort out their own problems without government intervention or "nannying." We wouldn't want to hamper the innovation of financiers with regulatory impediments. That stance gets trickier, though, when it comes to what they argue the Fed should do. Wall Street types tend to cheer for a rate cut because it stimulates growth, which they are positioned to capitalize on. But the intellectually consistent -- the ecnono-conservatives -- want to see the Fed, like lawmakers, do nothing (not cut the federal funds rate, that is), thereby letting those who got themselves into trouble with reckless borrowing or financing be punished. This, the argument goes, will prevent moral hazard -- the danger of lending recklessly because one is confident that the Fed will bail them out of any real trouble with a rate cut, the same way wearing a seat belt is presumed by some to make one a more reckless driver. Fed watcher James Grant, in a NYT editorial on Sunday, got into this:

What could account for the weakness of our credit markets? Why does the Fed feel the need to intervene at the drop of a market? The reasons have to do with an idea set firmly in place in the 1930s and expanded at every crisis up to the present. This is the notion that, while the risks inherent in the business of lending and borrowing should be finally borne by the public, the profits of that line of work should mainly accrue to the lenders and borrowers.
Nanny conservatives (as economist Dean Baker has styled them) -- the bad-faith free marketeers who want profit without risk -- expect government bailouts for poorly judged risks taken with ridiculous leverage but then fret and fulminate over "wasting" money on "handouts" to the poor. So it's nice to see some commentators stick to their guns, even to the point of arguing that a recession might do the U.S. some good, as the Economist does in its most recent issue.
The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries.
This logic would seem to be even more persuasive with regard to the current problems in the credit market, which are a matter not of misallocated capital but mostly what might be considered phantom capital -- paper assets generated by the loose money regime that has prevailed for the past half decade. What better than to blow away the profits investment banks secured without verifying the value of the underlying assets backing their loans -- assets that vanished with the subprime borrower's ability to make payments on a rejiggered ARM loan. Unfortunately these nonexistent assets were crafted (then aggregated and leveraged and collateralized and so on) from the toil of overstretched borrowers who seemed to have little idea of what they were getting into. Anecdotal reports suggest that many marginal mortgage borrowers were assured about the plausibility of their being able to make their payments by lenders who probably barely believed what they were saying. If the Fed bails out the financial sector with rate cuts, little of that benefit will trickle down to the borrowers already foreclosed upon, though the lenders will have already moved on to another round of victims, with fresh new cheap interest rates to tout.

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