After the 1974 crash, the government effectively promised that it would eliminate further recessions.  It proudly kept that promise.  Every time the markets stumbled, the Fed would throw massive amounts of cash at the economy.  Thus, the 1987 slowdown was terminated in just a couple of months.  The accompanying property boom and bust, which had been fueled by the savings and loans abusing their enhanced lending authority, was turned into a continuing boom by the government´s mitigation of losses through such vehicles as the Resolution Trust Corporation.

In 2000, the fed injected massive amounts of cash to avert the Y2K crash that showed no signs of occurring.

Financial risk had been eliminated!  Wall Street celebrated.   Conservative investors were fools.  Leverage became the name of the game.  No investment was too risky because there was no risk.  Banks created structured investment vehicles to hide their violation of capital requirements.  New, highly profitable instruments like collateralized debt obligations were invented that accomplished nothing except to hide risk by pushing it around.

Property values were sure to go up forever.  Therefore, the only smart tactic was to borrow more to buy more property.  As financial risk had been eliminated, diversification was stupid, regulation unnecessary.

The results were as widely recognized as they were ignored.  Aggregate savings were negative.  Housing became unaffordable.  Personal and corporate balance sheets were bloated with debt.  As a country, we fueled our appetite for risk by borrowing heavily from friends and enemies abroad.

But, of course, since risk is immutable it hadn´t gone away.  It had merely been deferred.  By this year, the financial pressures had grown so strong that even our great and magnificent government could no longer resist them.

The great un-leveraging that had to occur is now occurring.  In truth, despite the inevitable pain experienced by some, it isn´t all that serious.  Some overleveraged businesses have failed.  Some Wall Street zillionaires will see their earnings reduced to sustainable levels. Asset prices are dropping towards their true underlying values.  Housing prices have declined to their levels of a couple of years ago and, accordingly, housing is becoming affordable again.  The great benefit is that we are all relearning the basic truth of finance: risk can only be contained, it can´t be ignored.

But let us imagine that the government´s bailout is a total, immediate success.  The stock market recovers all its losses within days.  Housing prices return to record levels.  Financial instruments in default regain their prime status.  Wall Street executives buy even bigger yachts.  All is well again.  The celebration continues.

The result?  Risk again will be viewed as an anachronism.  Leverage will come thundering back and balance sheets will become even more bloated.  As a society we will borrow and spend more and more.

But, of course, risk will not have gone away.  It will still be there, sure to return with even greater force.  The next time, nothing will stop it.  It will crush us all.

The lesson to be drawn is that the expression of risk is an inevitable part of our economy.  The only way it can be controlled is to let downturns run their course.  Such downturns are the precursors of booms. (As the great economist Milton Friedman and others have shown, the Great Depression of the 1920s was a whole other thing, with no relevance to our present situation.) 

After the 1974 crash, the economy entered into a 30-year period of unparalleled prosperity.  The way to ensure the next prosperous period is to let the present shakedown clear out our economic cobwebs.  Accordingly, the newly enacted bailout bill is a mistake of historic proportions, assuring an incomplete correction and thereby setting the stage for the now inevitable forthcoming apocalyptic crash.

Roger Conant, who is trained as an economist, is president of the financial consulting firm CRI, Ltd.

October 8, 2008