08/13/2009 05:12 am ET Updated May 25, 2011

Failure To Assess Responsibility For Crisis Means Bad History, Bad Policy And Bad Politics

There's no way to move beyond the economic crisis without accounting -- literally and figuratively -- for the past. Daniel Berger explains why we need a commission-level inquiry into the financial meltdown, and how to keep it focused and productive.

The time has come to investigate the nature, origins, propagation and effects of the financial crisis. Unless we understand what happened and how it happened, we cannot get proper safeguards in place to prevent a re-occurrence. But a historical review of the events surrounding the crisis and the nature of the crisis is, in my opinion, even more important in terms of judging the validity of the political and economic philosophy being followed in this country and which currently underlies our public economic policy-making. And while we have numerous outstanding experts in the Congress, the Administration and the private and non-profit sectors hard at work on the policy fixes, there has been surprisingly little public discussion (at least in this country) of the larger philosophical issues relating to political economy and, in particular, the role of government oversight and regulation of the financial system.

The rise of the Chicago School

As a result of the financial crisis triggered by the collapse of the financial markets in 1929, the subsequent collapse of the national economy and the ensuing economic Depression of the 1930s, the nation instituted a mixed system of private financial markets and extensive government regulation and oversight. The mixed economy of private markets and public oversight served the nation well up to about 30 years ago, when things began to change and a different -- older -- approach to finance was increasingly substituted: the laissez-faire free market approach, sometimes referred to as the "Chicago School" approach. Under this view, a market system (including financial markets) was regarded as self-correcting and self-regulating and without need of government oversight and regulation. (This view harkens back to a prior, unregulated, anything-goes period in the history of American finance - a period whose excesses led to the catastrophe of the Great Depression.)

The Chicago School view had a specific application to financial markets in the form of the so-called "efficient market hypothesis" in which financial markets perfectly discount the value of financial assets at any given time and which postulates that any departure from the strict operation of market forces - - including, in particular, government regulation - - would cause economic inefficiencies in the creation and allocation of capital. The Chicago School view laid the foundation for the entire financial market de-regulation movement which we have witnessed over the last 30 years.

Just as the crisis in the 1930s has illustrated, and as repeated in the current crisis, the unfettered operation of market forces in financial markets produced not an efficient pricing of financial assets but, rather, financial asset bubbles (in the most recent manifestation, in housing and mortgage lending and financing) which deflated and which crippled the liquidity of major financial players leading to a credit crisis and a partial collapse of the real economy. Thus, not only did unfettered operation of financial markets routinely mis-price financial assets thereby invalidating the efficient market hypothesis, but financial markets themselves have exhibited dangerous instability. This later problem has utterly shattered -- once again -- the concept of a self-correcting, self-regulating financial system...

You can read the rest of Dan Berger's piece at New Deal 2.0.