2009 CPEO Brownfields List Archive

From: "Schnapf, Lawrence" <Lawrence.Schnapf@srz.com>
Date: Tue, 28 Apr 2009 12:41:05 -0700 (PDT)
Reply: cpeo-brownfields
Subject: [CPEO-BIF] Good Government and Animal Spirits (Akerlof and Shiller WSJ Op-Ed)
 
Title: Good Government and Animal Spirits (Akerlof and Shiller WSJ Op-Ed)

Lots of lessons and applications for environmental regulation………...

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.

 
Chad CroweThis 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 States and 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 University of California, Berkeley. Mr. Shiller is professor of economics and finance at Yale University and 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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U.S. Treasury Circular 230 Notice: Any U.S. federal tax advice included in this 
communication was not intended or written to be used, and cannot be used, for the 
purpose of avoiding U.S. federal tax penalties.
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