On the one hand, a free economy and the fractional reserve banking system underlying it are inherently unstable. It is unstable in a chaos theory kind of way. That is, while an economy's behaviour is deterministic, its forward trajectory in state space is unpredictable due to the sensitivity-of-initial-conditions problem. This means that it is almost impossible to predict the future behaviour of today’s financial crisis.
But while this is true about out economy, it is not all that is true about our economy.
What I am getting at is best described through analogy with physics. Most physical systems are chaotic in the same way. For instance, take the 'three body problem' in classical gravitation. There is no analytic solution that describes perfectly the motion of three bodies that takes into account their gravitational attraction to each other. This means that the forward trajectory of these bodies is unpredictable – and for the very same reason that our financial system cannot be predicted. But this does not mean that the system spins out of control.
Why not?
Because those three bodies are also governed by various conservation laws (mass, energy, momentum, angular momentum) that provide powerful constraints on what the system can do.
In the same way, there are similar constraints governing our financial system. Two of them are: 1) that in the long run, savings and investment must equal; and 2) that at any given time, the sum total of the wealth in our society is finite and equal to the amount of goods and services the economy produces. Let us look at each in turn to see how they constrain the economy in beneficial ways.
1. Savings must equal investment.
What does this mean? Savings are the money that you put away in the bank (or other financial vehicles) for future use. Investment is the concrete activity pursued for long-term profit. For instance, we build houses, factories, do R&D that will only pay off many years down the road, etc. These two things must equal, or there is trouble.
The best way to explain this is via another analogy. Consider an electrical grid. In a power grid, generation and load must be balanced at all times. And if they are not balanced, they will balance each other in ways that are undesirable. The same is true for investment and savings. If they are not balanced, then an unpleasant financial crisis will happen that will balance the two. This is where we are at now. This means that the only way forward is to balance savings and investment. This is why bankruptcies are healthy. They clear off bad, unproductive debt. As long as zombie companies like GM remain solvent, they will continue to burn through precious capital that could be used productively elsewhere and the economy will remain mired.
The S & L crisis of the early 90's was resolved when failed banks were processed through the Resolution Trust Company. Through the RTC, the government temporarily took over bad banks, consolidated and wrote off the bad debt and resold the banks that were left over - banks that were healthy, strong and capable of supporting constructive economic activity. Savings and investment were equaled. The result was the roaring 90's.
This explains why Keynsian pump priming is such a bad thing. The bubble is caused by savings and investment not equaling. The bubble bursting is savings and investment equaling in an unpleasant way. Government stimulus is essentially an attempt to reinflate the bubble -i.e. recreate the inequality that caused the problem in the first place. Bad private debt is replaced, or rather compounded, by government debt and money created from nothing by the central bank. The result is more savings redirected to unproductive ends. A real world example is Japan in the 1990's. Instead of letting bad banks fail - and letting bankruptcy courts sort out the good debt from the bad so that new and stronger financial institutions could replace them, they spent huge amounts of money on government programs in a vain attempt to reinflate the economy. The result was a lost decade and a public debt that currently equals over 190% (190!) of GDP, the highest in the developed world (only Zimbabwe is worse).
An example where the opposite was done was the depression of 1920-1921. The laissez faire policy of the Harding-Coolidge administrations and their excellent Treasury Secretary, Andrew Mellon, was to let everything fail that was going to fail. The result was a depression that was much sharper and more severe than the Great Depression, but one that was over in a year and a half. At the end of it, the bad debt was gone and the rest of the twenties roared.
2. At any given time, the sum total of the wealth in our society is finite and equal to the amount of goods and services the economy produces. This fact operates on the economy like the conservation of energy operates on a physical system. It restricts the severity of what can happen. A corollary is that money isn't wealth. So if the financial system creates highly leveraged financial products (such as derivatives and credit default swap) whose total dollar value ends up being greater than the total GDP of the country, it doesn't mean that the country’s net worth is less than zero. The net wealth of a country will always be the sum total of the goods and services it produces. Those goods and services are real. Money is merely a form of information. When the financial system is healthy, this information is an accurate reflection of real wealth. When the system is unhealthy, as is the case when there is a credit bubble, it is not. A bubble is really only an unevenly distributed bout of inflation. And inflation is when money fails to transmit information about wealth over time.
To understand this, it is important to remember that the primary function of banks is to allocate productive resources between direct consumption and long-term capital. (I.e. if you take $10 out of your pocket and buy a CD, you allocate productive resources to direct consumption. When you put that same $10 in the bank, that money is loaned out to the CD manufacturer to modernize his factory.) Because inflation interferes with the flow of information over time, it skews this allocation towards short-term production so that long-term investment suffers. In the long run, the economy slowly winds down as the factories wear out. Take the Weimer Republic, when people rushed to buy a loaf of bread before their money became worthless. In this environment, long-term investment is impossible. This is why inflation is bad. This is stagflation.
When financiers end up holding derivatives valued more than the economy, all that has happened is that a bunch of people think they are richer than they really are. The solution? Let them go bankrupt - as soon as possible. The longer they - and everybody else - labours under the illusion that they are rich, the more opportunity they have to misallocate precious capital. In order to minimize total damage, speed is of the essence.
The moral of the story is that the sooner bankruptcy is allowed to work its healing magic, the sooner we can put the recession behind us and the less total damage the recession will have caused. The flip side is short-term pain, a'la 1921.
Which is why everybody is avoiding the solution.