The title of this post is probably an accurate description of what's happened on Wall Street in the last year or so and especially the last 72 hours. And yet, the funny thing is that it's far from certain the US economy-- "Main Street"-- will be hurt, or hurt much.
What is the difference between a financial crisis and a crisis for the economy? In 1929 there was a financial crisis that led to an economic depression. In 1987 there was a financial crisis that basically had no effect on the economy. In 2001 a stockmarket bubble popped, without it ever being quite a crisis, and the economy slowed down a bit: it's generally regarded as a recession though I'm not sure it's clear that it meets the technical definition of two quarters of consecutive decline. So far, the US seems to have weathered financial crisis for a year without anything that can be legitimately called a recession, although Phil Gramm's accurate characterization of it as a "mental recession" has proven unpopular. What's the pattern? Is there a pattern?
Look at it another way: Why care about the financial sector more than other sectors? Suppose there were a crisis in the toilet-paper sector. Cheap toilet paper from Mexico, or a standards war, or mismanagement in toilet-paper giants lead to a collapse in domestic production, bankruptcies, lay-offs. No one would think the US economy as a whole was endangered by this development. Why is finance more important than toilet paper? It's bigger, but there seems to be a widespread impression that finance is important out of all proportion to most measures of its industry size.
There are good theoretical reasons to think finance is especially important. But it's difficult to establish how much the theory fits the reality. Or, if finance is important generally, what parts of finance matter, and how much, and why.
As an "economist"-- still in training, second-year PhD student with an earlier Masters involving PhD-level economics, and four years' work experience in econ-related positions-- I feel like I'm supposed to care about dramatic developments in Wall Street and have special insights about their significance. I'm not sure I do. Except maybe one thing. The biggest cause of the turmoil seems to be the decline in housing prices. The decline in housing prices is especially damaging because of the way it affects the functionality of the standard mortgage contract: when the price of a house falls, it no longer serves as effective collateral for the associated loans, giving people an incentive to walk away from their houses. For even a little bit of that to occur can have devastating ramifications. It seems to me that as long as America's unusual homeownership-cum-mortgage model is in place-- and although it's a bad model artificially created by distorting subsidies, don't expect it to go away soon (not that homeownership is bad, but America has way way way over-promoted it)-- the Fed cannot allow house prices to fall without crippling the financial system. And if it can't allow house prices to fall, it shouldn't allow them to rise, either, otherwise policy has an inflationary bias. So we need to re-define inflation to include home prices-- not rental prices, which are already included in the relevant indices, but home purchase prices-- and maybe other asset prices as well. It should be part of the Fed's mandate to prevent home prices from rising too fast. That means we should have had tighter money over the past decade or so, back to the Greenspan years.
Right now, I think we should tolerate just a bit more inflation temporarily so that housing prices can recover a bit, or anyway stop sliding, in order to shore up the financial system. At the same time, we should probably also explicitly think about the dollar's attractiveness as a world currency, since that's also been called into question somewhat over the past year and a half. But those goals conflict a bit. Hmm.