Should Policy Attempt to Avoid Financial Crises?

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from NCPA,

The 2008 financial crisis and the 2007-2009 recession have predictably spurred interest in how public policy can avoid financial crises. A prior question, however, is whether policy should seek to avoid financial crises. The answer might seem obvious. But, Jeffrey A. Miron, a senior fellow at the Cato Institute, argues that if policymakers focus on avoiding crises, they will generate undesired side effects and typically fail to avoid crises in any case.

Miron’s argument has four steps.

First, avoiding crises is not, in and of itself, the right goal for policy. Financial crises may not play a fundamental role in lowering output growth or increasing volatility.

Second, as a matter of theory, the costs of crises are not necessarily large. Many minor crises never became major crises, and many major crises were not associated with unusual output declines.

Third, as a matter of evidence, the costs of crises do not seem to be enormous. Crises may play a role in generating output declines, but they do not appear to be so deleterious that policy should be obsessed with avoiding them.

Fourth, whatever the costs of crises, anti-crisis policies might be worse than the disease. The crucial aspect of anti-crisis policy is the too-big-to-fail doctrine, which implies risk insurance that is likely to generate excessive risk taking.

No one likes the economic volatility or disruptions that accompany financial crises, so it is tempting to believe that government policy can reduce or eliminate them. Yet experience to date does not suggest that governments are good at eliminating volatility; indeed, in many instances, governments contribute to volatility. And, the policies that seek to reduce volatility have their own adverse consequences, chiefly the moral hazard created by implicit or explicit insurance.

A simple way to improve an economy’s average growth rate:

– Reduce the size of government.

– Let markets operate more freely.

In the case of the 2008-2009 recession, wasteful stimulus programs, costly financial regulation, the likelihood of increasingly redistributive taxation, the demonization of business success, the failure to address entitlement growth, and the adoption of ObamaCare were all likely to depress the economy independent of the financial crisis.

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