BERKELEY – Perhaps the best way to view a financial crisis is to look at it as a collapse in the risk tolerance of investors in private financial markets.

Maybe the collapse stems from lousy internal controls in financial firms that, swaddled by implicit government guarantees, lavish their employees with enormous rewards for risky behavior.

Or perhaps a long run of good fortune has left the financial market dominated by cockeyed optimists, who have finally figured that out. Or perhaps it stems simply from unreasoning panic.

Whatever the cause, when the risk tolerance of the market crashes, so do prices of risky financial assets. Everybody knows that there are immense unrealized losses in financial assets, but no one is sure that they know where those losses are.

To buy – or even to hold – risky assets in such a situation is a recipe for financial disaster. So is buying or holding equity in firms that may be holding risky assets, regardless of how "safe” a firm’s stock was previously thought to be.

This crash in prices of risky financial assets would not overly concern the rest of us were it not for the havoc that it has wrought on the price system, which is sending a peculiar message to the real economy.

The price system is saying: shut down risky production activities and don’t undertake any new activities that might be risky.

But there aren’t enough safe, secure, and sound enterprises to absorb all the workers laid off from risky enterprises.

And if the decline in nominal wages signals that there is an excess supply of labor, matters only get worse. General deflation eliminates the capital of yet more financial intermediaries, and makes risky an even larger share of assets that had previously been regarded as safe.

Ever since 1825, central banks’ standard response in such situations – except during the Great Depression of the 1930’s – has been the same: raise and support the prices of risky financial assets, and prevent financial markets from sending a signal to the real economy to shut down risky enterprises and eschew risky investments.

This response is understandably controversial, because it rewards those who bet on risky assets, many of whom accepted risk with open eyes and bear some responsibility for causing the crisis.

But an effective rescue cannot be done any other way. A policy that leaves owners of risky financial assets impoverished is a policy that shuts down dynamism in the real economy.

The political problem can be finessed: as Don Kohn, a vice-chairman of the Federal Reserve, recently observed, teaching a few thousand feckless financiers not to over-speculate is much less important than securing the jobs of millions of Americans and tens of millions around the globe.

Financial rescue operations that benefit even the unworthy can be accepted if they are seen as benefiting all – even if the unworthy gain more than their share of the benefits.

What cannot be accepted are financial rescue operations that benefit the unworthy and cause losses to other important groups – like taxpayers and wage earners. And that, unfortunately, is the perception held by many nowadays, particularly in the United States.

It is easy to see why.

When Vice Presidential candidate Jack Kemp attacked Vice President Al Gore in 1996 for the Clinton administration’s decision to bail out Mexico’s feckless government during the 1994-1995 financial crisis, Gore responded that America made $1.5 billion on the deal.

Similarly, Clinton’s treasury secretary, Robert Rubin, and IMF Managing Director Michel Camdessus were attacked for committing public money to bail out New York banks that had loaned to feckless East Asians in 1997-1998.

They responded that they had not rescued the truly bad speculative actor, Russia; that they had "bailed in,” not bailed out, the New York banks, by requiring them to cough up additional money to support South Korea’s economy; and that everyone had benefited massively, because a global recession was avoided.

Now, however, the US government can say none of these things. Officials cannot say that a global recession has been avoided; that they "bailed in” the banks; that – with the exception of Lehman Brothers and Bear Stearns – they forced the bad speculative actors into bankruptcy; or that the government made money on the deal.

It is still true that the banking-sector policies that were undertaken were good – or at least better than doing nothing.

But the certainty that matters would have been much worse under a hands-off approach to the financial sector, à la Republican Treasury Secretary Andrew Mellon in 1930-1931, is not concrete enough to alter public perceptions.

What is concrete enough are soaring bankers’ bonuses and a real economy that continues to shed jobs.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a Research Associate at the National Bureau of Economic Research.

Copyright: Project Syndicate, 2009.