Financial Reformers Remember: Market Flaws Can Be Government Flaws

As Obama seeks new financial regulation, don't assume that the regulators will be smarter than the market.

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In the Times yesterday, economist Robert Frank explains that the flaws in free markets that led to the financial crisis and recession are ultimately flaws in human nature. From there, it's an argument about why we need more government intervention to correct these flaws.

But there's one thing that needs to be added: Government is made up of humans, too. That's not an argument for inaction, but it is a reason to make sure that any "fixes" we implement don't just compound the problem.

Indeed, the flaws in markets are usually just as present in government action. Let me go through the flaws Frank discusses and give some examples of how they show up in government (also note that government has many flaws that are unique to it alone. I won't mention those here because there are too many to list in one post).

1. Relative performance matters more than absolute performance

Frank actually gives the best example of how governments, like markets, can get caught in races-to-the-bottoms that might help individual players but leave the group worse off: weapons proliferation and arms races.

2. Immediate and certain payoffs supersede delayed and uncertain payoffs

We saw this tendency at work in the federal government in the lead-up to the financial crisis. The Fed was willing to keep interest rates too low and help blow up the housing bubble because for much of the decade, it abated the post-9/11 economic downturn. That was the immediate and certain benefit, and it took precedence over the risk of a large recession if the bubble collapsed—the uncertain, far-off, but ultimately much larger cost.

3. Memories are short, and mistakes are repeated

The fact that people get caught up in economic bubbles again and again is evidence that it's part of human nature to repeat the mistakes of the past. But government in a democracy is usually only as good as its voters. So government can be equally forgetful. The federal government is now repeating the same kind of bailouts that many economists argue created the risky behavior that is now used to justify the new bailouts. Read about the 1998 bailout of Long Term Capital Management for more.