Uncertainty About Government Actions Slows Recovery

In the commentary quoted below, Tyler Cowen makes the important point that recovery from the current economic crisis is being slowed by uncertainty about what the government will do next. While the uncertainty lasts, consumers will consume less, and investors will invest less.
Amity Shlaes has made a similar point about the Great Depression. Uncertainty about what policies FDR would try next, kept investors from risking their money in new entrepreneurial ventures.

(p. 5) The financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad.
. . .
. . .    Today, . . . , that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.
. . .
While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.

For the full commentary, see:
TYLER COWEN. “Economic View; Bailout of Long-Term Capital: A Bad Precedent?” The New York Times, SundayBusiness Section (Sun., December 26, 2008): 5.
(Note: ellipses added.)

For the Amity Shlaes book mentioned above, see:
Shlaes, Amity. The Forgotten Man: A New History of the Great Depression. New York: HarperCollins, 2007.

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