I recently read Shiller and Akerlof's book, Animal Spirits. Great book. I emphatically believe that more attention should be paid to developing the field of behavioral economics, the increased use of principles from psychology and sociology in economic analysis.
A large part of the book's thesis is that the philosophy of the free market knowing best all the time is flawed because markets are composed of people who are not always economically rational. A recurring metaphor throughout the book is that the economy is a sporting event in which businesses are the players and the government is the referee. Shiller and Akerlof are strong proponents of the government reigning in the irrationality of the animal spirits. However, I just want to point out that animal spirits can have just as much, if not more of an affect on bad government policy as they do on bad business policy. Shiller and Akerlof are 100% correct that there should be a defined set of rules that require "fairness." Many rules have always been in place and are critical to a well functioning free market such as: accurate and accessible information, prohibition of unregulated monopolies and personal accountability.
The current economic crisis was a failure in incentives and the role of government should not simply be to "prevent bubbles," because how can the government know what is bubble and what is actual growth. In hindsight, it becomes very clear that the housing bubble was unsustainable; however, there were many debates in congress where elected officials were also drinking from the kool-aid under the very same assumptions that mismanaged banks were. I don't see any reason to believe that larger government will necessarily solve this problem.
Lets start with the facts: all individuals make decisions to maximize their utility. People's utility, although commonly correlated with money, is infinitely more complex than simply living by the "show me the money" mantra. I know many people will be saying, "What about people sacrificing themselves for the good of others." That is a great point - and the answer is that people do that because of the benefit they derive from helping others and/or maintaining a view of themselves that they are the type to do such things.
People make decisions that are consistent with the stories of the world around them and how they view themselves to fit into the world. For example, the books notes that during the real estate bubble, people were constantly reminded how many people's net worth was skyrocketing thanks to leveraged bets on real estate. Many of those participating in the bubble pointed to a ridiculous explanation for the rapidly rising rates: since the human population is always increasing and the amount of land on the earth remains constant, real estate prices will always go up! Many people were skeptical, but with real estate prices continuing to rise for years, the story gained even more credibility. The story of the time was simple, people are getting rich from investing in real estate. Since people consider themselves to be smart and crafty when it comes to recognizing opportunities, it made sense to many people to feed into this irrational exuberance -another point for Shiller. The story of the day did not include the risk since for so long, the story worked and the naysayers were "proven" wrong. Well as we know, just because a condition held in the past does not mean that the condition will hold indefinitely.
The metaphor I like to use for such a failure in risk management is that of a town with two paths of travel - a road or shortcut along a railroad track. Lets assume in this town that if you take the shortcut by traveling on the railroad track you reach your destination in half the time it would take if you walked on the road. Lets assume that the people in this town have no idea whether the railroad is active and have no control over whether or not a train will come. We'll also assume that the train will come in five years. In the first year of this imaginary town, many people would say, "Whoaaa, don't walk on the railroad track, a train can come and run you over!" Some others would say, "Nahhh, it's not coming - I've never seen a train come by on the track." As time goes on and the train doesn't come, more people would move to the latter camp until the train eventually comes and runs them over.
In the real estate bubble, people were running on the railroad track assuming that the train would never come. Shiller and Akerlof's solution to this condition is that the government should reign in the crazy villagers. I think that the caveat with this solution is that too much government intervention can be dangerous when the animal spirits comprising the government are fooled as well.
We must be careful not to just think in simple terms of private sector bad, government good. The government is run by these same animal spirits - in fact - since politicians are more concerned with how the general public views them, they can be even MORE susceptible to animal spirits. Further, the mechanism for correcting bad managers many times of more efficient than the mechanism for replacing bad government officials.
In our current situation, the bad assumptions that the economy relied upon were the same assumptions that the government was championing as government sponsored entities Fannie and Freddie were loading up their balance sheets with sub-prime debt. Shiller and Akerlof note that there was a big political push to expand home buying and to loosen credit standards. The government was pushing dangerous sub-prime lending - albeit with noble motives.
As we all live in a time where conventional economic theories have been turned upside down and the system as we know waits for a major change - there really is one starting point where everything must stem from and that is incentives. These incentives are not always economic, they are not always intuitive, but they are always the single driving force of every decision. The government's role should be to fix distorted incentives and act as the ref in the football game - however, we must be careful about how we choose the ref and his incentives so as not to make the game even worse. It really is a balancing act since the worst game would be a super powerful ref essentially deciding the winners and losers.
