Everybody Calm Down. A Government Hand In the Economy Is as Old as the Republic.
By Robert J. Shiller
Sunday, September 28, 2008; B01
It has become fashionable to fret that the current crisis on Wall
Street marks the end of American capitalism as we know it. "This
massive bailout is not the solution," Sen. Jim Bunning (R-Ky.) warned
Tuesday. "It is financial socialism, and it is un-American." It is
neither. The near-collapse of the U.S. financial system and
Washington's sudden and massive intervention to try to shore it up
certainly mark a major turning point, but a bailout would represent a
thoroughly American next step for our economic system - and one that
will probably lead to better times.
Americans may assume that the basics of capitalism have been firmly
established here since time immemorial, but historical cataclysms such
as the Great Depression strongly suggest otherwise. Simply put,
capitalism evolves. And we need to understand its trajectory if we are
to bring our economic system into greater accord with the other great
source of American strength: the best principles of our democracy.
No, our economy is not a shining example of pure unfettered market
forces. It never has been. In his farewell address back in 1796, 20
years after the publication of Adam Smith's "The Wealth of Nations,"
George Washington defined the new republic's own distinctive national
economic sensibility: "Our commercial policy should hold an equal and
impartial hand; neither seeking nor granting exclusive favors or
preferences; consulting the natural course of things; diffusing and
diversifying by gentle means the streams of commerce, but forcing
nothing." From the outset, Washington envisioned some government
involvement in the commercial system, even as he recognized that
commerce should belong to the people.
Capitalism is not really the best word to describe this arrangement.
(The term was coined in the late 19th century as a way to describe the
ideological opposite of communism.) Some decades later, people began
to use a better term, "the American system," in which the government
involved itself in the economy primarily to develop what we would now
call infrastructure - highways, canals, railroads - but otherwise
let economic liberty prevail. I prefer to call this spectacularly
successful arrangement "financial democracy" - a largely free system
in which the U.S. government's role is to help citizens achieve their
best potential, using all the economic weapons that our financial
arsenal can provide.
So is the government's bailout a major departure? Hardly. Today's
federal involvement offers bailouts as a strictly temporary measure to
prevent a system-wide financial calamity. This is entirely in keeping
with our basic principles - as long as the bailout promotes, rather
than hinders, financial democracy.
Which, so far, it seems to. Congressional critics may be right to
demand more help for homeowners and more accountability for Wall
Street blunders, but the core idea of the plan is sound: to protect
the financial infrastructure. Remember, Fannie Mae used to be a
government entity, and by taking it over, the federal government is
merely returning to the status quo ante. The measures to take toxic
debts off the hands of financial and insurance firms are intended only
to deal with a crisis, not to transform our financial system. The
proposals do not represent any landmark change in the American way of
prosperity. Everyone should take a deep breath. Changing our thinking
about finance does not mean abolishing capitalism, but it does raise
questions about what the changes mean.
Whenever the public endures a crisis, ordinary citizens start to
wonder how - and whether - our institutions really work. We no
longer take things for granted. It is only then that real change
So the current crisis got me thinking back to 1990, the year before
the collapse of the Soviet Union, when I worked with two Soviet
economists, Maxim Boycko and Vladimir Korobov, to try to understand
the different belief systems in their country and mine. We carried out
identical surveys in Moscow and New York, comparing answers about
fundamental notions of capitalism, and published our results in the
American Economic Review. We expected to find that the Muscovites
possessed scant understanding of how capitalism really works. But we
found that they actually understood free-market dynamics better than
the New Yorkers. We concluded that the Muscovites had proved more
savvy precisely because their system was in crisis - something that
encouraged them to rethink their most fundamental notions.
We Americans are going through a similar change right now. We no
longer think that our financial future will be determined by
securities brokers or inhumanly large investment banks. The most
important question is not, "What form should these temporary bailouts
take?" It is, "What are we really learning from all this?"
We should be learning a great deal. The current crisis offers us a
singular opportunity to reevaluate fundamentally the safety and
permanence of the master financial institutions that we have come to
take for granted as part of the national economic landscape. Over
these past few turbulent weeks, we have learned that the monolithic
investment banks are mortal: They are mostly gone, or absorbed by
other banks. We have learned that what we called "cash" and considered
perfectly safe is not necessarily so secure.
So we are groping around for something else to trust. We should be
open to thinking about a new set of financial arrangements - a better
financial democracy - that can restore the public's faith in the
economic principles espoused by Washington more than two centuries
ago. Here are some key features:
1. Handle moral hazard better. The term "moral hazard" refers to the
pernicious tendency some people have of failing deliberately if they
think it's advantageous to do so. Moral hazard is used to justify
teaching people a lesson for their failures - the same logic that
once justified "debtors' prisons." (Yes, we really did have them.) But
over the course of the 19th century, Americans grew more realistic
about laying blame for economic catastrophes and started eyeing other
parties besides the hapless and the bankrupt. The demise of the
debtors' prisons reflected Americans' changing ideas about the meaning
of a contract.
By rescuing Wall Street tycoons who succumbed to the lure of an
irrationally exuberant housing bubble, the bailouts today do pose
something of a moral-hazard problem. But we can more than repair it by
defining a new generation of financial contracts, with a continuation
of our evolving thinking about moral hazard, reflecting greater
enlightenment, greater understanding of human psychology and the means
to deal with financial failure. For example, I have proposed replacing
the conventional mortgage with what I call the "continuous-workout
mortgage" - one that would spell out in advance the conditions under
which borrowers would see their debt reduced in a rocky economy. These
conditions would be designed to minimize moral hazard: The borrowers
would not be able to make the debt reduction happen deliberately.
2. To limit risks to the system, build better derivatives. Some of
today's derivatives - the complex bundles of toxic real estate loans
that helped drag Lehman Brothers down - turned out to be "financial
weapons of mass destruction," as the legendary investor Warren E.
Buffett warned back in 2003. The problem isn't derivatives per se but
a certain kind - derivatives that spun a massive web of
over-the-counter contracts, relying on the solvency of countless banks
and other institutions, and ultimately endangered the entire financial
system when they fell apart. Some kinds of derivatives, such as those
maintained by futures exchanges using procedures that effectively
eliminate the risk that the other party in the agreement will default,
are more useful - and far safer - than others. It is high time to
redesign derivatives to avoid what Buffett called "mega-catastrophic"
3. Trust markets, not Wall Street titans. If institutions can be said
to have charisma, such giants as Lehman Brothers and Merrill Lynch
certainly had it in spades. But these firms proved not to be the sole
source of financial intelligence. They were merely meeting places for
smart, financially savvy people - and for some reckless folks
besides. We need to learn to trust people and markets rather than
institutions. This means developing better markets that will allow us
to hedge against the kinds of risks that dragged us into this crisis,
such as real estate gambles.
4. Ideas matter. Maybe next time, we will listen more closely to
financial theorists who think in abstract, general terms. Consider the
Long-Term Capital Management debacle in 1998, when the Federal Reserve
leaned on financial titans to rescue a massive hedge fund and stave
off global fallout. Lots of people hold that the moral of the LCTM
story was the failed thinking of two of the firm's founders, Robert
Merton and Myron Scholes, both of whom were Nobel Prize-winning
financial theorists. In fact, the collapse of LTCM was largely due to
the overconfidence of bond trader John Meriwether and some of his
other LTCM colleagues, who were gambling in the markets. The disgraced
Merton has been working for the last decade trying to build better
risk-management systems, mostly to little avail. Maybe he will be
heard now. People still seem to want to trust businessmen who have
made bundles and have a huge investment bank behind them, rather than
listen to experts who are thinking about the fundamentals of risk
management. We would have been better off this month if we'd been
ignoring the former and listening to the latter.
These and other improvements in the contemporary economy - a better
financial information infrastructure (so that people can gauge risks
better), broader markets (so that people can manage big risks, such as
real estate loans) and better retail products (such as
continuous-workout mortgages) - will need to be discussed, debated
and delivered in the days ahead. If we move smartly, Americans can
have a better, more robust financial democracy along the lines of the
system envisioned by our first president. The current crisis does not
mean the end of American capitalism. But if we are lucky, it will mean
an important step in its evolution.
Robert J. Shiller is a professor of economics at Yale and chief
economist of MacroMarkets LLC. His books include "Irrational
Exuberance" and, most recently, "The Subprime Solution: How Today's
Global Financial Crisis Happened and What to Do About It."