President Obama's former White House Chief of Staff Rahm Emanuel said that “you never want a serious crisis to go to waste.” Though he had something different in mind when he made this statement, a severe crisis, for all its bad parts, is an opportunity to learn important lessons. But that opportunity is wasted if the lessons are missed, or, worse, if we learn the wrong things.
There are several important ways in the present crisis has been wasted, making it much more difficult to reduce the frequency and severity of future economic crises. The first and most important is that unregulated markets — free markets — do not necessarily produce optimal outcomes. Free markets are not the same as the perfectly competitive markets needed to produce ideal, textbook outcomes, and they can fail in many ways. Free markets can be monopolized, impose externalities on society, exploit asymmetric information, defraud consumers, create unsafe but highly profitable working conditions and so on. Nothing guarantees that these problems will disappear on their own, and there is a need for laws, regulations and social norms to create the conditions necessary for markets to best serve our needs.
to ensure that markets work optimally is not the path
to prosperity.
The false belief that free markets will always magically transform into ideal competitive markets was one of the problems that led to the financial crisis. Markets that should have been regulated due to the presence of asymmetric information, monopoly power, moral hazard, fraud, political influence, and other problems were left to regulate themselves with disastrous consequences.
We have taken some steps to shore up the financial system, but not enough has been done, and it’s far from clear that the general lesson has been learned. Just the other day, for example, John Boehner said that “You don’t get to prosperity by taking freedom away from the people who create jobs. You achieve prosperity by getting government out of their way.”
But an economy free of the government oversight needed to ensure that markets work optimally is not the path to prosperity. It’s a path to markets inundated with problems that benefit the few at the expense of many, and to suboptimal economic performance.
The second most important lesson that we have failed to learn has to do with fiscal policy. Many people have concluded that fiscal policy doesn’t work, but the experiment upon which this conclusion is based was flawed. The stimulus package was too small, too late, not well targeted, and weighted too heavily toward tax cuts. In addition, and, importantly, the stimulus at the national level wasmostly offset by cutbacks at the state and local level leaving a net stimulus near zero. Even so, things would have been much worse without the federal offsets to the declines at the state and local level. The lesson we should have learned is that fiscal policy needs to be more aggressive and timely, that there should be more spending relative to tax cuts, and that the failure to support state and local governments struggling under balanced budget requirements is a recipe for extending the crisis and increasing its severity.
Fiscal policy is a crucial tool for fighting recessions, and the false conclusion that it hasn’t worked will be costly the next time a crisis hits and policymakers are reluctant to provide the aggressive fiscal policy that is needed.
A third important unlearned lesson involves the financial bailout. With a financial system teetering on the edge of collapse, there was no choice but to bailout systemically important banks that were in trouble. However, the manner in which the bailout was executed has caused a public backlash. The problem is that the people who had a hand in creating the crisis, and profited so much as the housing bubble inflated, were rewarded handsomely when too-big-to-fail financial firms were bailed out. Regulators involved in the decision claim they had no choice; legal restrictions prevented them from using the type of resolution process that would have allowed regulators to force losses on equity holders. Their only choice was to allow too-big-to-fail firms to fail and risk a complete collapse and depression, or bail out the firms and, as a consequence, reward the very people who should have borne the losses.
There is an attempt to fix this with the Dodd-Frank legislation. Resolution authority is now available and it is supposed to avoid costly bailouts, but there is considerable doubt about whether this will work in a real crisis. If not, and Congressional action is needed to stem a financial collapse, the understandable lack of public support for such policies will make it very difficult for Congress to act. If public anger over the first bailout prevents effective government action the next time it’s needed, and it very well could, the result could be disastrous.
The overarching lesson in all of this is that getting government out of the way isn’t always the best path to prosperity. The crisis should have taught us that government has an essential role to play in preventing problems from occurring in the economy, and in correcting problems when they occur despite our attempts to prevent them. But, unfortunately, due to poorly executed policy, political posturing, obstructionism in Congress, and ineffective rebuttal from the administration, that’s not the lesson that has been learned.
