Tuesday, January 13, 2009

Acemoglu on the financial crisis

Daron Acemoglu argues:

…Free markets are not unregulated markets. Well-designed institutions and regulation are necessary for the proper functioning of markets. Institutions have received more attention over the past 15 years, but focus was on understanding why poor nations were poor – not on understanding which institutions are necessary as the basis of markets and for continued prosperity in advanced economies.

…The first point is that fixing the short-run problem with policies that harm long-run growth is a bad option from a policy and welfare perspective. Innovation and reallocation are the keys to long-run growth, but potentially powerful groups tend to resist such changes. In developing nations, it is easy for impoverished populations suffering from adverse shocks and economic crises to turn against the market system and support populist, anti-growth policies. These threats are as important for advanced economies, particularly in the midst of the current economic crisis.

…A comprehensive stimulus plan, even with all of its imperfections, is probably the best way of fighting these dangers. Nevertheless, the details of the stimulus plan should be designed so as to cause minimal disruption to the process of reallocation and innovation. Sacrificing growth out of our fear of the present would be as severe a mistake as inaction. The risk that the belief in the capitalist system may collapse should not be dismissed.

Finally, wrong notions that led economists to ignore the impeding problems:

  • Astute policy and new technologies had ended the era of aggregate volatility.
  • The capitalist economy lives in an institutional-less vacuum where markets miraculously monitor opportunistic behaviour.
  • We could trust the long-lived large firms to monitor themselves because they had sufficient “reputational capital”.