Keynes was worried about a liquidity trap – the inability of monetary authorities to induce an increase in the supply of credit in order to raise the level of economic activity. US Federal Reserve Chairman Ben Bernanke has tried hard to avoid having the blame fall on the Fed for deepening this downturn in the way that it is blamed for the Great Depression, famously associated with a contraction of the money supply and the collapse of banks.
And yet one should read history and theory carefully: preserving financial institutions is not an end in itself, but a means to an end. It is the flow of credit that is important, and the reason that the failure of banks during the Great Depression was important is that they were involved in determining creditworthiness; they were the repositories of information necessary for the maintenance of the flow of credit.
But America’s financial system has changed dramatically since the 1930’s. Many of America’s big banks moved out of the “lending” business and into the “moving business.” They focused on buying assets, repackaging them, and selling them, while establishing a record of incompetence in assessing risk and screening for creditworthiness. Hundreds of billions have been spent to preserve these dysfunctional institutions. Nothing has been done even to address their perverse incentive structures, which encourage short-sighted behavior and excessive risk taking. With private rewards so markedly different from social returns, it is no surprise that the pursuit of self-interest (greed) led to such socially destructive consequences. Not even the interests of their own shareholders have been served well.
Meanwhile, too little is being done to help banks that actually do what banks are supposed to do – lend money and assess creditworthiness.