OPINION * APRIL 23, 2009, 9:49 P.M.
EThttp://online.wsj.com/article/SB124052797951850225.html
Good Government and Animal Spirits
Every talented player understands the importance of a strong
referee.
By GEORGE
A. AKERLOF and ROBERT
J. SHILLER*
The principal long-term result of the
current financial crisis should be improved financial regulation. After the
immediate crisis is over, we need to restructure our fragmented system. This
process will take years to complete since, if properly done, it should get at
the heart of the regulatory structure.
This is not as radical as it sounds, for
while many observers equate U.S.-style capitalism with unconstrained free
markets, the story is more complicated. Americans have long understood that for
the economy to work well, government must play an important supporting role.
They've also long understood the important role that self-regulatory
organizations (SROs), such as trade associations and exchanges, play in
cooperation with government regulation.
An understanding of animal spirits -- the
human psychology and culture at the heart of economic activity -- confirms the
need for restoring the role of regulators as guiding hands in a healthy,
productive free-enterprise system. History -- including recent history -- shows
that without regulation, animal spirits will drive economic activity to
extremes.
The debate about the proper role of
government in the economy goes far back in American history. At the beginning
of the 19th century, the Democrats were fiercely opposed to government
intervention, while the Whigs thought that the government should provide the
backdrop for a healthy capitalism. On the federal level, this would mean
support for a bank of the United Statesand a system of national roads, as part
of
the "American System" advocated by Henry Clay starting in the 1820s
and supported by John Quincy Adams. Andrew Jackson and later Martin van Buren
were against such federal government intrusions.
Controversy about the proper relationship of
the government and the economy has continued since then. The recent economic
turmoil has brought back to the table many questions that had been considered
settled. People are seeking new answers, urgently.
There have been several major shifts in
American history on this large issue: at the time of the Revolution; after the
elections of Andrew Jackson and, later, of Abraham Lincoln; at the end of
Reconstruction; during the Great Depression; and after the election of Ronald
Reagan. Now we hope and expect we are seeing a shift that will be remembered in
association with Barack Obama. If the president (with the help of Congress and
our SROs) brings about this shift, it will be something far more important than
the soon-to-be-forgotten stimulus and the bailouts he has overseen to date.
At the end of the 1980s, our economic system
was remarkably well-adapted to weather any storm. For example, massive numbers
of S&Ls failed during the decade. But government protections isolated this
collapse into a microeconomic event that, while it cost taxpayers quite a bit
of money, only rarely cost them their jobs.
Then the economy changed -- as it always
does -- challenging the regulations that were in place. The housing market
illustrates this perfectly.
Commercial and savings banks used to have
reason to be careful initiating mortgages -- they would most likely hold the
debt for years. But banks would increasingly sell the mortgages they initiated
to others. And regulation did not adapt to reflect this change in the financial
structure. The regulatory failure led to a profound systemic instability in our
economy, which accounts for the severity of our economic crisis. Devising new
regulatory structures that will allow financial innovation to proceed and yet
prevent new such systemic problems is the major challenge to our creative
capitalism today.
Public antipathy toward regulation supplied
the underlying reason for this failure. The U.S.was deep into a new view of
capitalism.
Americans believed in a no-holds-barred interpretation of the game. We had
forgotten the hard-earned lesson of the 1930s: Capitalism can give us real
prosperity, but it does so only on a playing field where the government sets
the rules and acts as a referee.
Contrary to a widespread impression the
current situation is not really a crisis of capitalism. Rather we must
recognize that capitalism must live within certain rules. And our whole view of
the economy, with all of its animal spirits, indicates why the government must
set those rules. It may be true that in the classical economic paradigm there
is full employment. But with animal spirits, waves of optimism and pessimism
cause large-scale changes in aggregate demand. Since wages are determined
partly by considerations of fairness, these changes in demand do not translate
uniformly into shifts in prices and tend to cause shifts in employment. When
demand goes down, unemployment rises. It is the role of the government to mute
those changes.
Moreover, entrepreneurs and companies do not
just sell people what they really want. They also sell people what they think
they want, and not infrequently what they think they want turns out to be snake
oil. Especially in financial markets, this leads to excesses, and to
bankruptcies
that cause failures in the economy more generally. All of these processes are
driven by stories. The stories that people tell to themselves -- about
themselves, about how others behave, and even about how the economy as a whole
behaves -- all influence what they do. These stories vary over time.
Such a world of animal spirits justifies the
economic intervention of government. Its role is not to harness animal spirits
but really to set them free, to allow them to be maximally creative. A
brilliant player wants a referee, for only when the game has appropriate rules
can he really show his talents. While the sports of baseball and football
haven't changed much in the last century, the economy has -- and American
financial regulation hasn't had an overhaul in 70 years. The challenge for the
Obama administration, along with the U.S. Congress and our SROs, is to invent a
new and better American version of the capitalist game.
________________________________
*Mr. Akerlof is the 2001 Nobel Laureate in
Economics and a professor at the Universityof California, Berkeley. Mr. Shiller
is professor of economics and
finance at YaleUniversityand chief economist at Macromarkets LLC.
They are co-authors of the recently published "Animal Spirits: How Human
Psychology Drives the Economy, and Why It Matters for Global Capitalism"
(Princeton).
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