The Current Economic Crisis and Lessons for Economic Theory

These are exciting times: the worst economic crisis since the Great Depression, the first global recession in the new era of globalization, and a new President committed to restructuring national priorities, reforming our education, health, and energy sectors, eliminating some long standing distortions arising from corporate welfare, and restructuring our tax code. For economists who have fought long for many of these ideas, the President’s budget was a moment of celebration. The final recognition that the atmosphere is a global public good, that we have failed to price one of the most scarce economic resources, and that going forward we would do so, was music to an economist’s ear. There will be political battles ahead. Special interests will try to block many of the reforms. The future of our nation will depend in no small measure on the outcome of those battles. Today, however, I do not want to dwell on these great initiatives. I want to address two issues. The first is a matter of immediacy: what should we do about our failed banks? The second is a matter of reflection: what role did we, the economics profession, or more precisely, what role did some of the ideas that had become fashionable, even dominant, play in causing this crisis? What lessons will or should we take away? How should it affect what we teach, what we advise governments to do, and what our research agenda is? THE CRISIS Turning first to the crisis. We have at long last emerged from the paralysis, from the period of denial, from the notion that recovery was around the corner. For years, it has been clear that America’s growth was not sustainable. It was based on a real estate bubble, which sustained a consumption boom. America was living beyond its means. Alan Greenspan may have been right that you could not be sure that there was a bubble until after it broke, but policy-makers are supposed to make decisions based on the analysis of risk. The likelihood that there was a bubble was increasingly clear; and the more housing prices grew, the greater the likelihood that the eventual crash would be disastrous. How could prices continue to grow, especially for housing for lower and middle-income individuals, as incomes stagnated? One doesn’t have to have a Ph.D. to know that you can’t spend more than 100 percent of your income on housing. Over inflated housing prices allowed Americans to take out hundreds of billions of dollars in mortgage equity withdrawals, in 1 year alone an estimated US$900 billion. It has also long been clear what was required: a stimulus package, a program to deal with the housing market, and a program to deal with the financial sector.