"The importance of political economy has also been underscored by recent events"

Simon Johnson on the Baseline Scenario:

"We are not short of causes for our current economic crisis. The basic machinery of capitalism, including the process of making loans( FRAUD, ETC. POOR LENDING PRACTICES. ), did not work as it was supposed to. Capital flows around the world proved much more destabilizing than even before( ONLY BECAUSE OF INDIVIDUAL HUMAN ACTIONS. ) (and we’ve seen some damaging capital flows over the past 200 years.) And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it( FRAUD, ETC. ).

But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles or with how we think about the world( THIS IS CLOSE ). All of our thinking about the economy - a vast abstract concept - has to be in some form of model, with or without mathematics. And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and - unless fixed - will lead to further instability down the road ( TRUE ).

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” (If you like to check intellectual credentials( WOW. I'M IMPRESSED. ), start here and if you don’t understand what I mean about models, look at his new book.) To me there are three major points in his essay.

1. The seeds of the crisis were sown in the Great Moderation (the low inflation, relatively stable last 20 years or so). Everyone who patted themselves or others on the back during that time was really missing the point (p.3). The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.

2. The predominant view was that the US and other relatively rich countries had pretty good institutions (i.e., rules, laws and practices underpinning economic transactions) and that these institutions would prevent powerful people( THAT'S A JOKE. RIGHT? ) from the kind of abuse that endanger social systems in many parts of the world (pp.4-5). That view was incorrect. (Speaking personally, I had no illusions about the power of the strongest on Wall Street - particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001. But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system( A CRIMINAL SYSTEM, AND ONE DEPENDENT ON GOVERNMENT UNDERPINNING. ).

3. The way we think about reputation, including how it is acquired and maintained, is way off base (pp.6-7). This is fundamental for both formal economics and how you go shopping. You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered. But, Daron points out, this is too simple. In particular, we should no longer make the mistake of saying “the company” wants this or that. There are no companies in any kind of behavioral sense. There are people( INDIVIDUALS. FANTASTIC. ), struggling to get ahead, and it is their interactions that can lead - particularly in finance - to products that are really terrible for you and your neighbors (and even quite bad for themselves).

Daron also urges that we not lose track of longer term economic growth issues in the current policy debate. If the bailout process - including the evergreening of credit by the Federal Reserve - slows down or even freezes the reallocation of resources out of the financial sector, we have a problem. We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.( THAT WILL HAPPEN. IT ALREADY IS. SEE THE MANUFACTURING INVESTMENT NUMBERS. )

This is not an argument against a comprehensive stimulus package. But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals( POSSIBLY CRIMINAL ) for leading financial figures (received so far and no doubt currently pencilled in). Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics( POLITICAL ECONOMY ) of how we rebuild the financial system. If we recreate something fundamentally unfair and unstable( WHICH WE HAD ), that will also undermine growth."

This is from the Acemoglu post:

"The …nal principle that I would like to emphasize relates to the politi-
cal economy( YES ) of growth. Economic growth will only take place if the soci-
ety creates the institutions and policies that encourage innovation, realloca-
tion, investment, and education. But such institutions should not be taken
for granted( EXACTLY ). Because of the reallocation and creative destruction brought
about by economic growth, there will always be parties, often strong par-
ties, opposed to certain aspects of economic growth. In many less-developed
economies, the key aspect of the political economy of growth is to ensure
that incumbent producers, elites and politicians do not hijack the political
agenda and create an environment inimical to economic progress and growth.
Another threat to the institutional foundations of economic growth comes
from its ultimate bene…ciaries. Creative destruction and reallocation not
only harm established businesses but also their workers and suppliers, some-
times even destroying the livelihood of millions of workers and peasants. It
is then easy for impoverished populations su¤ering from adverse shocks and
economic crises— particularly in societies where the political economy never
generated an e¤ective safety net— to turn against the market system and
support populist policies that will create barriers against economic growth( MY FEAR ).
These threats are as important for advanced economies as they are for less-
developed countries, particularly in the midst of the current economic crisis( I AGREE ).
The importance of political economy( TRUE ) has also been underscored by recent
events. It is di¢ cult to tell the story of the failure of regulation of investment
banks and the …nancial industry at large over the past two decades and
of the bailout plan approved without some reference to political economy.
The United States is not Indonesia under Suharto or the Philippines under
Marcos. But we do not need to go to such extremes to imagine that when
the …nancial industry contributes millions to the campaigns of Senators and
Congressmen that it will have an acute in‡uence on policies that in‡uence
its livelihood or that investment bankers setting up— or failing to set up as
the case may be— the regulations for their former partners and colleagues
without oversight will likely lead to political economy problems. It is also
di¢ cult to envisage a scenario in which current and future policies will not
be in‡uenced by the backlash against markets that those who have lost their
houses and livelihoods feel at the moment."( VERY TRUE )

I disagree with some of it, but you would be wise to read it.