Henry Simons On Corporate Finance and The Business Cycle
According to Simons, financial disturbances in the economy are perpetuated by "extreme alternations of hoarding and dishoarding" of money. Short-term obligations (loans) issued by banks and corporations effectively create "abundant (fiat) money substitutes during booms". When demand becomes sluggish, a sector of the economy undergoes a shrinkage, or the economy as a whole begins to lapse into depression, "hopeless efforts at liquidation" of the secondary monies, or "fire sales," result.
Simons believed that a financial system so structured would be "repeatedly exposed to complete insolvency". In due course, government intervention would inevitably be necessary to forestall insolvency due to traders' bad bets and margin calls by lenders.
A recent example would be the $10 billion bailout by the Federal Reserve of Bear Stearns, a multinational global investment bank, in 2008. John Mauldin, a senior member of the financial services industry, writes: "If Bear had not been put into sound hands and provided solvency and liquidity, the credit markets would simply have frozen… The stock market would have crashed by 20% or more… We would have seen tens of trillions of dollars wiped out in equity holdings all over the world." The Bear Stearns debacle was a watershed event in a housing market crisis that precipitated massive devaluations, left the economy reeling, and required massive government action.
This is precisely the chain of events predicted by Henry Simons in the event of a large-scale liquidation of inflated securities such as mortgage loans. In Economic Policy for a Free Society Simons writes that all it takes to precipitate a massive liquidation of securities is "a relatively small decline of security values". Simons is emphatic in pointing out that corporations that traded on a "shoestring of equity, and under a mass of current liabilities" are "placing their working capital precariously on call," and hence at risk, in the event of the slightest financial disturbance.
Read more about this topic: Henry Calvert Simons
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