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Home , Milton Friedman

Benjamin M. Friedman & Robert M. Solow

Introduction Downloaded from http://direct.mit.edu/daed/article-pdf/139/4/5/1829892/daed_e_00037.pdf by guest on 01 October 2021 The ½nancial meltdown of 2007 to 2009 folks. Apart from the sheer theater of it was surely a great spectacle. Mighty all, the main reason for caring about a names toppled like that statue of Saddam ½nancial crisis is the well-founded belief Hussein. Lehman Brothers, with a histo- that serious disturbance of the ½nancial ry spanning a century-and-a-half, just dis- system can impair the functioning of the appeared. Bear Stearns and even Merrill real , perhaps drastically. A well- Lynch–the same Merrill Lynch that had behaved ½nancial system makes the real taught generations of small to economy more ef½cient at producing be “bullish on America”–were sold off well-being for its inhabitants (though it at discounts suitable for used furniture. may parcel out income and wealth to spe- aig was rescued in the nick of time, but ci½c groups among those inhabitants in only with $182 billion of U.S. government ways that we and they may ½nd objection- assistance. Trillions of dollars of inves- able, and maybe even repugnant). But a tors’ wealth simply evaporated. One breakdown of the ½nancial system can could think, “Oh, well, easy come, easy inflict damage on the real economy, dam- go.” But still, trillions of dollars? It was a age that may last for years after the break- spectacle all right, but why did it really down has been repaired. And so it has. matter to the rest of us, who count our- These connections between the real selves merely as citizens of the republic? economy and the ½nancial system can be After all, the economic well-being of far from simple. In this issue of Dædalus, a society and its members depends on essays by Edward L. Glaeser of Harvard “real” outcomes: on the production and University and Jeremy C. Stein, also of of current output, some of Harvard, show how an episode of over- it allocated to current of building of houses, the sort of thing that and services and some to provision might normally lead to a run-of-the- for future consumption through mill slowdown or minor , can , research activity, and edu- be ampli½ed and complexi½ed by the cation (all of depreciation, resource (mis)behavior of ½nancial institutions depletion, and environmental damage). and the spread of securitization. We That is what the economy delivers to us therefore end up with a disaster for the real economy–and for millions, or tens © 2010 by the American Academy of Arts of millions, of its inhabitants. Instead of & Sciences a recession that can be dealt with by rou-

Dædalus Fall 2010 5 Benjamin tine monetary and ½scal policy, we face tion of the assumptions that have stood M. Fried- the loss of more than eight million jobs behind a generation of Reagan/Thatcher man & Robert M. and years of lost output, not to mention “let the markets rule” policies–and the Solow the indirect social costs of prolonged framework behind those pol- on the ½nancial recession. It is all the more galling that icies, associated with Milton Friedman crisis & much of the damage is borne by innocent in an earlier era and Alan Greenspan economic bystanders, while many of the bad (or more recently–is enormous. policy stupid or greedy) guys do fairly well. A second, less obvious lesson is that an The meaningful story is about the in- elaborate ½nancial system, with its mys- teraction of ½nancial activity and the teries, its glamour, its possibilities for in- real economy. The mechanics of this stant wealth, can quietly distort the direc- connection are far from transparent. tion of the real economy; it can induce Many of the articles in this issue focus, the real economy to spend human and Downloaded from http://direct.mit.edu/daed/article-pdf/139/4/5/1829892/daed_e_00037.pdf by guest on 01 October 2021 to varying degrees, on aspects of this material resources on activities that can dif½cult and important matter, and on lead to immense private pro½t for some the ways in which a society can hope to of those engaged while nonetheless mak- bene½t from a highly developed ½nan- ing little or no contribution to general cial system while protecting itself, more well-being. Some of the following arti- or less, against the damage that its pro- cles, in particular, essays by Benjamin M. clivity to malfunction can inflict. Essays Friedman, Lucian A. Bebchuk of Harvard by Luigi Zingales of the University of School, and of Chicago Booth School of and the University of , Berkeley, of the Massachusetts Insti- focus on these dangers and the search tute of Technology aim to elucidate the for public policies that can fend them intellectual apparatus that off with minimal handicap to ef½cient and students of ½nance have built to help ½nancial activity. them understand this complex piece of As we saw during the yearlong debate machinery. over what ½nally became the Dodd-Frank One important lesson, driven home Wall Street Reform and Consumer Pro- with great force by the breakdown itself, tection Act (passed by Congress in July is the potential of an elaborate ½nancial 2010), attempts to legislate effective lim- system like ours for instability, a subject itation and regulation of ½nancial activi- which Benjamin M. Friedman of Harvard ties–in the search for a viable combina- University, Robert M. Solow of the Mas- tion of ef½ciency and protection–run sachusetts Institute of Technology, and into the formidable lobbying power and Jeremy C. Stein each take up in their es- political clout of the ½nancial industry says. The crisis has dramatically demon- itself. In their essay, Nolan McCarty of strated that our kind of system, instead , Keith T. Poole of of responding to errors and disequilibria the University of Georgia, Thomas Romer by self-correcting, gradually or quickly, of Princeton, and Howard Rosenthal of can magnify initial errors many times, University provide insight into and then spread them by contagion the challenge of regulating ½nance in throughout the ½nancial system and the face of political forces. Nor has the even to areas of the real economy that lobbying abated now that the numer- seem remote from the initial source: ous agencies charged by Dodd-Frank witness the path from housing bubble with making new rules, and otherwise to general crisis. The contradic- implementing the changes that the law

6 Dædalus Fall 2010 mandates, have begun their work. The to pay more explicit attention to the risk- Intro- widening inequality of income and wealth iness, as well as the volume, of assets held duction in the United States has consisted largely by the ½nancial sector. In the meanwhile, of an enormous increase in the incomes as of this writing, despite record-low long- of those at the very top of the heap, the term rates and no sign of infla- best-off 1 percent or (even more so) one- tion anywhere, many observers of U.S. tenth of 1 percent, with near stagnation , especially in the ½nan- lower down. Those tippy-top incomes are cial markets, seem terri½ed that any move often pocketed by the leading ½gures in toward monetary expansion would soon the ½nancial services business. They are unleash irresistible inflationary forces. not likely to give them up without an all- The same fear paralyzed monetary policy- out ½ght; and those same deep pockets makers in Japan for more than a decade can generate a lot of political leverage, in following that country’s ½nancial crisis Downloaded from http://direct.mit.edu/daed/article-pdf/139/4/5/1829892/daed_e_00037.pdf by guest on 01 October 2021 both parties. The optimistic view is that in the early 1990s, with the predictable we are lucky to have got as much as we result of ongoing economic stagnation. did by way of improved regulation out To conclude that, with short-term inter- of the stonewalling, horse-trading, and est rates at zero, monetary policy can do dependence on “contributions” that nothing further is arguable if not neces- pervade today’s Congress. sarily correct; to argue that monetary pol- With or without new regulation, dis- icy should do nothing further seems, under ruption in the ½nancial system will in- today’s circumstances, hard to fathom. evitably disrupt the real economy from The analysis of ½scal policy is, in many time to time. So will other disturbances, respects, the same no matter where the like the occasional sharp increase in shocks to the real economy come from. world oil or simply a turn toward But Robert E. Hall makes the important pervasive pessimism among business point that the hallowed tendency of most executives deciding on their ½rms’ cap- central banks to “lean against the wind” ital spending programs. Two of the fol- means that any expansionary impulse, lowing articles, by C.A.E. Goodhart of whether from ½scal policy or elsewhere, the London School of Economics and is likely to be partially resisted by the Robert E. Hall of , through an increase in reconsider the standard defenses against short-term interest rates. (One is entitled shocks to the real economy: monetary to ask why this should be so: aren’t the policy and ½scal policy. Now that the Federal Reserve and the ½scal authorities worst of the ½nancial crisis is behind us, in Congress part of the same government, and the debate over ½nancial reform has trying to do what is right for the same been consummated in the Dodd-Frank economy? Why should the right hand legislation, these policies have become undo what the left is doing?) In the after- the focus of much of the current eco- math of a ½nancial crisis like the one we nomic debate. have just experienced, however, when the Monetary policy, which today means Federal Reserve has pushed short-term mostly policy–the domain interest rates all the way to zero and pre- of the U.S. Federal Reserve System and sumably wishes they could go even fur- other central banks elsewhere–is natu- ther, this monetary policy reaction to any rally more directly connected to ½nan- ½scal seems unlikely. Fiscal pol- cial events; C.A.E. Goodhart thus argues icy therefore becomes a substantially that future monetary policy-makers need more effective tool in a deep recession.

Dædalus Fall 2010 7 Benjamin This insight makes the immediate state In the wake of the ½nancial crisis, it M. Fried- of affairs around the industrialized world is understandable that consumers and man & Robert M. more visibly dysfunctional. The United , conscious of vanished wealth Solow States and the major European and uncertain about the future, would on the ½nancial have barely started to climb out of a seri- be reluctant to spend. As economists crisis & ous recession, and they have not even be- have recognized since observing what economic gun to make good the two years of lost happened in the 1930s, such behavior policy growth. and excess ca- may be individually rational, even if in pacity are still high and persistent. No- the aggregate it makes things worse for body believes that the next two years everyone. Governments, by contrast, look promising. One would think this are supposed to think about the health represents just the sort of circumstance of the economy as a whole, and to off- when ½scal policy is at its most potent, set, or more than offset, such tempo- Downloaded from http://direct.mit.edu/daed/article-pdf/139/4/5/1829892/daed_e_00037.pdf by guest on 01 October 2021 and most needed. Yet most of the talk in rary de½ciencies in demand for what both the United States and Germany, the the economy normally produces. Today Western world’s two bellwether econo- they instead seem to be poised to re- mies, is, incomprehensibly, about ½scal inforce them. Four-legged lemmings contraction: about de½cit reduction, to be no doubt look on with astonishment. achieved via lower public spending and, possibly, higher . True, the United States has a long- term budget imbalance that needs to be addressed (maybe even with legislation enacted now, to take effect later, when the economy has more nearly returned to ); but pursuing ½scal retrenchment now seems at best perverse, and in suf½cient force, a suicidal recipe for renewed and protracted economic downturn. In Europe, some countries– Greece and Portugal, for example–prob- ably will have to undergo deep and last- ing , not just because their and spending policies have got so far out of line with one another in recent years, but because their prices and costs have drifted far compared with those of other European economies and, as members of the common- (Euro) group, they cannot simply alter their exchange rates to correct the problem. But the like- lihood of severe weakness in those Euro- pean economies that have to have it is all the more reason for those that don’t, like Germany, to remain strong; not for them to pursue recession-inducing policies, too, merely for their own sake.

8 Dædalus Fall 2010