The Response to the Economic Crisis

12/26/2008 05:12 am ET | Updated May 25, 2011

The crisis in the economy's financial markets has now cascaded into a severe economic downturn. In response, policy-makers have been forced to give up the fiction that markets are self-regulating and that there is no need for the government to intervene in their functioning. It has provided resources to financial institutions, engineered the take-over of some financial houses by others and become a part-owner of the large insurance company, A.I.G.

But as welcome as is the end of laissez-faire ideology, the government interventions that have occurred have been distinctly one-sided. To date, virtually all of the money expended by the government has been provided to financial institutions. That these expenditures have not reversed the economic slide downward points to the fact that their adoption has less to do with their effectiveness than with the fact that financial sector is the single most important source of political campaign funds. The government policies that have been adopted reflect the political influence that campaign contributors provide to big donors.

As a result, in both the short-run and the long-run, our society suffers. In the near term, we have failed to adopt the policies that have the greatest likelihood of successfully stimulating the economy. Over the long-term, the policies that have been implemented make it less likely that we will successfully address our long-term needs. The vast amounts of money that are being inefficiently spent today mean that it will be difficult to find the funds to use on the urgent needs of tomorrow.

The clearest example of the short-run misallocation of resources concerns our failure to provide adequate assistance to mortgage holders. Mortgage foreclosures mean that banks take over houses and then try to sell them. The resulting increase in supply depresses home prices, worsening the already fragile financial foundation of the banks. The financial system would be far better served if the government stabilized housing prices by providing relief to hard-hit home owners. But in a political setting where political contributions influence policy and where most mortgage-holders cannot make big political contributions, they lack the clout necessary to save both themselves and the banks.

A similar pattern exists with regard to the question of financial regulation. Virtually all observers agree that the financial meltdown was triggered by government's failure adequately to regulate the markets that emerged for "products" such as derivates and credit default swaps. These markets developed outside of the purview of existing regulations, and the participants in these markets used their wealth and lobbying power to ensure that regulations were not extended to them. Even today, a year and a half after two hedge funds owned by Bear Stearns collapsed, nothing has been done to bring these and other exotic financial assets under regulatory control. The irony of their financial clout is that it is self-defeating. Probably nothing would do more to instill enhanced investor confidence in financial markets than the knowledge that there is a policeman on the beat responsible for making sure that the information that is provided is clear and accurate and that insider trading is under control.

The government's response to the economic crisis has similarly perverse consequences for the long-run. Two of the biggest challenges facing the country have been neglected. In order to mitigate damaging climate change, we urgently need to develop non-fossil fuel technologies to generate electricity. And in order to reverse the trend towards increased income inequality, we will have to upgrade the quality of education in our public schools and ensure that more people can afford to attend college. Neither can be done cheaply, but increased expenditures on each could be part of a strategy to stimulate the economy in the short-run. However, since the people affected by public education are not among the largest political donors, and since environmentalists rank near the bottom of contributors, cut-backs are occurring in these areas rather than increased spending.

In a crisis, fault lines become clear. Free market principles clearly have been found wanting, and thankfully we are quickly moving beyond that ideology. But because our political system too much reflects the power of wealth, we have failed to develop a political response that can speak to the society's urgent short and long-term needs.