Friday, January 9, 2009

Where do we go from here?

MIT economist (and 2005 John Bates Clark medal winner) Daron Acemoglu just published an essay on what the economic crisis means for economists and economic theory. It's a terrific piece in both its insight and honesty. In particular, I think two points are worth highlighting. First, Acemoglu writes:
"Our second too-quickly-accepted notion is that the capitalist economy lives in an institutional-less vacuum, where markets miraculously monitor opportunistic behavior. Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets. Although we understand that even unfettered competitive markets are based on a set of laws and institutions that secure property rights, ensure enforcement of contracts, and regulate firm behavior and product and service quality, we increasingly abstracted from the role of institutions and regulations supporting market transactions in our conceptualization of markets."
It's easy to forget the institutional context of economics, particularly in the developed world.  But one lesson from this crisis is that we cannot simply take institutions for granted.  "Free markets" require institutions to work, including formal institutions (the courts) and informal ones (norms governing business practice).  It's good to think that moving forward we'll pay more attention to these factors.

Second, Acemoglu writes:
"In my opinion, however, the greater danger from an expectational trap and a deep recession lies elsewhere. We may see consumers and policymakers start believing that free markets are responsible for the economic ills of today and shift their support away from the market economy. We would then see the pendulum swing too far, taking us to an era of heavy government involvement rather than the needed foundational regulation of free markets. I believe that such a swing and the anti-market policies that it would bring would be the real threat to the future growth prospects of the global economy. Restrictions on trade in goods and services would be a first step. Industrial policy that stymies reallocation and innovation would be a second equally damaging step. When the talk is of bailing out and protecting selected sectors, more systematic proposals on trade restrictions and industrial policy may be around the corner."
Again, this highlights the difference between "free" and "unregulated" markets.  Any response to this crisis will inevitably result in a larger role for government in the economy.  This is not necessarily a bad thing.  A renewed commitment to proper regulation can strengthen our economic system.  At the same time, interfering with the "free" aspect of the economy--that is, the decentralized system of allocating resources--can reduce prosperity for all.  

The process of economic change can be painful, and certainly there is a role for government in helping to reduce individual suffering by providing social insurance and opportunities for education and retraining.  But it's also the process that creates wealth in society.  The government, by sheer force of will, can keep jobs in Detroit or any other area of the economy.  But it can't make inefficient industries viable again.  It can kick the can down the road, but eventually we'll all be paying for our mistakes.

Capitalism has taken a bit of a beating in the past year.  But we should separate out what we did badly from what we do well.  Let's not throw the baby out with the bath water.

No comments: