Summer (and Fall) Reading

I would like to draw my readers' attention to four recent important contributions to the debate over our economic crisis.

The first, which unfortunately will not be published until the fall, is a book by Robert C. Pozen entitled Too Big to Save? How to Fix the US Financial System. A lawyer, a lecturer at the Harvard Business School, and the chairman of a large asset-management firm, Pozen is an immensely experienced and acute student of the financial system. His book is not only a detailed yet thoroughly lucid and accessible study of the financial crisis; it is also, and more important, the best critique I have seen of the government's responses to the crisis and its recent blueprint for financial regulatory reform. I hope that his analysis can somehow be conveyed to the Administration and Congress before the government makes irrevocable mistakes in its response to the crisis.

The second contribution is a special issue of the journal Critical Review (vol. 21, issues 2-3, 2009) entitled "Causes of the Crisis." (It is about to be published, and can be ordered at the following web site: It is a collection of essays dealing with the causes of our current economic crisis. The long introduction by the journal's editor, Jeffrey Friedman, entitled "A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure," is a particularly good summary of what can at this early stage in our understanding be said with some confidence about the causes of the mess. Without meaning to denigrate any of the other essays, all of which are useful, I found particularly welcome the acknowledgement by economists, including Daron Acemoglu and David Colander, of what Colander and his coauthors call the "systemic failure of the economics profession." This is a point that I stressed in my book but that has received insufficient recognition by the economics profession (naturally).

I do wish, however, to take exception to a tendency in Professor Acemoglu's essay to belittle the current global depression. He says that "despite the ferocious severity of the global crisis--and barring a complete global meltdown--the possible loss of GDP for most countries is in the range of just a couple of percentage points--and most of this might have been unavoidable anyway, given the overexpansion of the economy in prior years. In contrast, within a decade or two, we may see modest but cumulative economic growth that more than outweighs the current economic contraction."

There are, it seems to me, three errors in the passage that I have quoted. The first is the suggestion that the only cost of a depression is a temporary, and relatively minor, decline in GDP. This ignores the profound psychological effects of a depression, including the anxieties of those who lose their jobs or their homes or their retirement incomes or fear losing them (a series of costs that tenured professors tend to underestimate because they are largely immune from them). It ignores long-term economic effects--the aftershock danager that I keep emphasizing--as a result of the immense costs that governments are devoting to measures for halting the economic decline and speeding recovery.And it ignores political effects with economic consequences, such as increased size and intrusiveness of government.

The second error in the passage that I quoted is the suggestion that the fact that "most of [the loss of GDP] might have been unavoidable anyway, given the overexpansion of the economy in prior years," somehow mitigates the severity of the downturn. The idea may be that people were living high on the hog because of excessive borrowing and this is repayment time. But probably most of the people hurt are people who were not living high on the hog during the boom years; and even those who were may have lost more than they had gained during the boom.

The third error is the suggestion that when GDP returns to its pre-depression level, the cost of the depression will be wiped out. That ignores the fact that many and perhaps most of the beneficiaries of the higher GDP will not be the same people who lost in the bust. This is underscored by the phenomenon of "job destruction." Many jobs lost in a depression never come back; their occupants are not rehired and must therefore either leave the workforce altogether or find other types of job, which usually pay less. And few of the people whose jobs are destroyed will have been contributors to the economic collapse and therefore appropriately punished by a fall in their permanent income.

The third contribution is a soon to be published article by two law professors, Saule Omarova and Adam Feibelman, "Risks, Rules, and Institutions: A Process for Reforming Financial Regulation," 39 University of Memphis Law Review 881 (2009). The article discusses a number of proposals for financial regulatory reform, but its main significance is its careful attention to the process of effective regulatory reform. The authors properly emphasize the importance of careful, step-by-step program design, based on a solid body of knowledge. The Administration could with profit heed their suggestions.

Last, a website called is well worth reading. It describes the project of the Committee to Establish a National Institute of Finance. The Institute would be responsible for gathering and analyzing data concerning systemic risk. The proposal is consistent with my belief that the essential need is better monitoring of systemic risk; the regulatory powers of the Federal Reserve, the SEC, and other regulators of financial institutions probably are adequate, though perhaps some relatively minor statutory changes would be desirable. The problem is not power but knowledge.