Economist Anna J Schwartz co-wrote what's often regarded as the definitive account of the causes of the Great Depression, with Nobel Laureate Milton Friedman, no less. So when an article by Schwartz on the "origins of the financial market crisis of 2008" appears in a new book (available for free online) from the Institute of Economic Affairs, it's probably a good idea to pay attention.
Here's what Schwartz pinpoints as the three most significant lessons to avoid financial crises like the one in 2008:
-don't lower interest rates to a level that makes borrowing appear riskless
--be wary of untested financial innovations like mortgage-backed securities
--avoid fundamentally flawed instruments like the pre-credit crisis market for auction-rate securities, which appeared long-term to the borrower but short-term to the lender
Schwartz puts that first lesson at the top because it's the most significant. So as we debate about the competing regulatory reform plans going around Washington, remember that all that debate is essentially avoiding the elephant in the room: the Federal Reserve made a mistake, and there's not much Congress or the president can do about it. It's a sobering and not reassuring thought that even if somebody as qualified and brilliant as Alan Greenspan is selected for Fed chairman, there's no guarantee that even he has all the knowledge necessary to avoid economic catastrophe.
But as for those other two lessons, politics can actually accomplish something here. How do we get investors to be more careful and avoid these risky financial instruments? One way is to change the incentives so that those who use these instruments know their mistakes will have negative consequences. That's one place where I think the GOP plan gets it right: a definitive declaration of "no bailouts" would go a long way to changing those incentives.