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So this is what a financial catastrophe feels like. Yesterday, the House of Representatives rejected the government-sponsored bailout bill, and the Dow Jones industrial average experienced its biggest point drop ever. Every single stock in the index declined, and some stocks, including GM (NYSE: GM ) , Intel (NYSE: INTC ) , and Bank of America (NYSE: BAC ) , fell by more than 10 percentage points.
Despite the warnings of seasoned investors such as Warren Buffett, Bill Gross, and John Mauldin on the need to pass this bill quickly, a majority of our representatives decided that doing nothing was preferable to the possible solution at hand.
Up to this point, the government had pursued a fairly active policy. It supported the takeover of Bear Stearns by JPMorgan Chase (NYSE: JPM ) back in March. More recently, it took action to save Fannie Mae (NYSE: FNM ) , Freddie Mac (NYSE: FRE ) , and AIG (NYSE: AIG ) .
One of the only times the government chose to look the other way -- when it allowed Lehman Brothers to implode -- may well have been what led to the current meltdown, according to The Wall Street Journal.
Regardless, yesterday's "nay" vote signals that the "do nothing" policy (or, perhaps, the "not do this" policy) is in the ascendant. And as a result, the prognosis for our economy is not good. In fact, it's really, really dire.
History provides us with an example of when the "do nothing" approach was applied to a financial catastrophe. The economist J. Bradford DeLong points out that the American government did little to prevent the onset of the Great Depression during the period from 1929 to 1933. He quotes President Herbert Hoover on those individuals who counseled inaction:
The "leave-it-alone liquidationists" headed by Secretary of the Treasury Mellon … felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." … He held that even panic was not altogether a bad thing. He said: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life.
According to DeLong, "liquidationism" was a very powerful current of thought arguing against any government action to alleviate the Great Depression in the early 1930s.
The great economist John Maynard Keynes viewed the disease and remedy very differently. He famously wrote:
I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity.
What would Keynes think?
Keynes, who once referred to politicians as "madmen in authority," would likely be pessimistic about the chances that Congress will figure out something in time to unfreeze our credit markets. In my opinion, we need to pass this bill now to stabilize our markets, and buy time to come up with more creative solutions. With greater stability, we might be able to pursue improved regulatory policies and new measures to limit the harmful effects of foreclosures.
Doing nothing, however, is not an option worth pursuing at this critical time. Ironically, Hoover realized that himself when writing his memoirs in the 1950s.
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