The Crucible

Casey Mulligan’s important post on the relative separability of the performance of the financial and non-financial sectors of the economy (among many other refreshing and illuminating posts) highlights what I think are some of the great neglected facts of the ongoing discussion about the implications of the financial crisis.

First, financial markets are a necessary instrument to wealth creation, but are not a fundamental cause of increasing prosperity. It is a tremendous problem of economics journalism that journalists and opinionators don’t really understand the mainsprings of economic growth. Financial innovation affects growth at the margin by more efficiently allocating capital to its most efficient uses, but this is obviously secondary to developments in the real economy that increase capital’s productivity. Derivatives can make us a bit richer, but productivity-enhancing technologies make us rich.

The conditions for entrepreneurial discovery, and therefore scientific and technological and organizational innovation, and therefore productivity growth, and therefore increasing prosperity and welfare remain very, very strong. Yes, if the flow of capital to would-be innovators dries up, then innovation and growth dries up. But there is in our system enormous ongoing potential for innovation, and therefore for increasing returns to capital. And there is an enormous amount of capital, the owners of which continue to want a nice return. The magnetic force between capital and innovation is so strong, and our overall institutional environment so sound, that we can be pretty sure innovation and growth will continue with barely a hitch. The financial crisis is not going to keep us from getting a hell of lot richer.    

I think it’s pretty clear that our recent troubles are primarily due to a variety of misconceived U.S. government policies intended to promote home-ownership, and secondarily due to combined financial market irrationality and regulatory failure. Suppose you agree that the government screwed up in failing to regulate leverage. What does this imply about the feasibility of relatively free-market capitalism? What does it say about the desirability of government regulatory intervention into the non-financial economy–the part that actually delivers prosperity. Very little.

What does it say about the alleged dangers of free market ideology? Again, very little, if anything. I think Ross Douthat put it extremely well in his reply to Jacob Weisberg’s silliness:

[A]rguing that a single bad economic contraction following a long period of growth permanently discredits an ideology that can be implicated in both the growth and the contraction is like arguing that, say, Weimar Germany permanently discredits partisans of democracy.

Past and furture Treasury Secretary Larry Summers does understand a something about the deeper sources of economic prosperity, and thus in his FT op-ed titled “The Pendulum Swings Toward Regulation,” he says almost nothing about regulation (just leverage, really), and concentrates on the ways government subsidies might at once soften recession and enhance the productivity of the real economy.  

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

I happen to think Summers is making a mistake in believing that government has adequate information or motivation to do a very good job at identifying growth-enhancing investments (in energy, biotech, broadband, or otherwise), but the implied broader point is that financial markets are a sideshow. The real economy is where it’s at, and the best the government can do is to promote the enabling conditions of innovation and growth. The contemporary debate was and continues to be whether government spending can complement or enhance relatively free markets, not whether we will be better off if those markets are more heavily regulated and relatively less free.

Indeed, I think the evidence points to overregulation of the economic uses of many forms of “intellectual property.” More generally, the evidence that dominant firms support regulation that increases the cost of entry into their markets remains overwhelming. Thanks these sorts of regulations, we’ve foregone a lot of innovation and growth.  At a smaller scale, regulation of small business — most notably the businesses poorer people are likely to start — continues to suppress a lot of welfare-enhancing entrepreneurship. Libertarians continue to lead the way in emphasizing all this, and continue to be right about all of it. We have witnessed nothing in the financial markets to reinforce the wisdom of this kind of welfare-reducing regulation.

Libertarians and other free market cheerleaders have made huge permanent strides in convincing the world of the importance of entrepreneurial discovery, competition-driven innovation, and the role of rent-seeking regulation in hobbling these. The prevalence of these ideas has made the world much wealthier, and stands to make it wealthier still. Larry Summers might not jump at the chance to admit this, but neither do I think he would disagree. He’ll just emphasize that active government spending can nevertheless be growth-promoting. That’s not much of a “pendulum swing” back toward a more regulated economy. If we’re really in the middle of a PR nightmare for capitalism — if this is our big generational crisis of confidence — and the importance of things like infrastructure upgrades and subsidies for renewable energy is the upshot for the left-leaning economic policy establishment, then what we’re going through amounts to the fire-tempering, the locking down, the consolidation of decades of libertarian-leaning economic policy gains.