We are currently in uncharted territory concerning the consequences of the huge monetary and fiscal stimuli applied to counter the financial crisis and the economic downturn. Consequently, we are confronted with an elevated potential for surprises and black swans. However, nothing has been learnt from the abject failure to predict the financial market crisis. Although some analysts may indeed be concerned about “extreme” outcomes (2-3 sigma events), the true black swan events (4+ sigma events) are probably not given enough consideration, and hedges against them are probably underpriced by financial markets.

There are, by definition, no black swan “seers” – a black swan is, by definition, unexpected. Therefore, don’t rely on the cranks-turned-celebrities who warned of the financial market crisis to warn you of the next black swan, because the signs on the wall will be written in a different language. Those few who were able to read these signs two years ago won’t be able to read them next time, and those who warned of the crisis, but were right only by chance, won’t be able to read them either. It will be different cranks and different lucky analysts who will turn out right next time.

I think we are already inmidst serious inflation. Although consumer prices are falling in many countries, this does not imply we are experiencing deflation. Inflation is not defined as rising consumer prices, inflation is defined as a fall in the value of money because of an excessive increase in the quantity of money. Consumer prices are one (out of several) indicators of inflation. Because consumer prices are sticky, i.e. consumer goods are not traded on liquid markets, consumer prices are a lagging indicator of inflation. Most real-time indicators of inflation point to rather high inflation: growth rates of monetary aggregates around the world are massive, and the purchasing power of the US dollar has been falling on almost every liquid market for several months now (foreign currency, commodities, stocks). Consumer prices will probably follow other prices in due time.

This sounds logical, but it is not. In particular, some things are badly mixed up. Actually, inflation could probably result with government support being much smaller than wealth losses.

First, real estate, stock, and risky credit were overpriced at the onset of the financial market crisis – their valuations were not backed by an equivalent stream of future production. Note that wealth is nothing else than a claim on future production. Therefore, pre-crisis levels of asset prices did not reflect actual wealth – in fact, there was no chance that these overpriced assets could ever have been converted into future production at prevailing prices. Expectations reflected in asset prices were exaggerated. In order to balance future aggregate demand and supply of goods and services, either consumer prices would have had to rise, or asset prices would have had to fall. The latter happened.

Enter the government. By reinflating prices of worthless assets above their intrinsic value, false wealth is restored. Furthermore, by backing AIG and honouring bets which were not honourable from the beginning, even more false wealth is created. Trying to restore exaggerated expectations is probably a bad idea and could turn out very inflationary.

The second flaw in the introductory reasoning is that apples are compared to oranges. A dollar in wealth (losses) is not the same as a dollar in money supply, which is not the same as a dollar actually spent for goods or services. In particular, wealth and money supply are stock variables, while spending is a flow variable. Simply aggregating the headline amount of government measures and comparing them to estimated wealth losses is therefore useless at best, if not misleading, in order to assess future inflationary tendencies.

It appears that Nemesis, executrix of justice, finally made up her mind that enough is enough. By calling the Furies to appear on Earth and sending them after the perpetrators of the current financial mess, justice should be restored. As an economist, I have no idea how the financial and economic crises are going to play out. However, taking guidance from mythology, the crisis might be far from over. Despite the severity of the crisis, there is still obvious and widespread fraud, corruption, arrogance and ignorance going unpunished, mainly in the financial sector. For divine justice to be be served, the crisis will have to worsen significantly.

Today, there is no doubt any more that governments will intervene in order to save illiquid and insolvent banks, systemically important and unimportant banks, insurance companies, states, countries, industries, home-owners, shareholders, management, and about everyone else who can plausibly argue that he needs a bailout and who can write (because you need to be able to fill out a two-page application form).

Basically, moral hazard makes agents behave more risk-seeking than is optimal for a society as a whole. There are several consequences of the increase in moral hazard. First, by definition, society as a whole will fare less well. Second, as soon as the current deleveraging will be over, risk-love and speculation could return with a vengeance. The next bubble, wherever it will be, will be something to behold. Third, an increase in moral hazard is equivalent to an expansion of monetary policy. This expansion represents a significant (and probably underestimated) boost to the economy and financial markets. Fourth, in the longer run, moral hazard increases systemic risk even further – the next bust might definitely finish off what this bust will have left over.

Moral hazard is the main culprit for the current financial crisis – investors, managers, and basically the whole society behaved recklessly because they were conditioned to be bailed out. The current instance has shown once again that in a democracy with a fiat currency regime, no laws can prevent large-scale bailouts to take place, and that expectations of a bailout are thus justified ex ante. Ultimately, there is probably just one way to credibly prevent governments from bailouts, and thus to eliminate the moral hazard problem – namely to render bailouts financially impossible. The possibility to inflate money supply must be taken away from governments. This could be implemented, for example, by backing money with commodities, possibly gold. The wheel does not have to be reinvented.