A few thoughts on bubbles, busts, markets, and the role of government:
Some people ask how markets can be trusted to be rational when so many people aren’t. Or they use examples of irrational decisions by people to claim that markets can’t and don’t work right. Market theory is based on people pursing their own economic self-interest, they say, so how can markets work if people can’t figure out their own self-interest or don’t properly pursue it?
The fact is markets can be rational, and in fact usually are rational, even though individual people are often irrational and short-sighted. The reason this works is that the irrationalities and short-sightedness of individual people disappear when they are all averaged together in the market.
But what about bubbles? A bubble can occur when too many people are irrational or short-sighted in the same direction, thus throwing the average off. The question is what government can or should do in such a situation. The proper answer is: not much.
If government sees irrationality and shortsightedness pushing the market too far in one direction, in theory it could try to lean the other way to balance things out. But that expects too much of government. If that many people are irrational or shortsighted in one direction, government will probably be that way too. Therefore, as a general rule, the best thing for government to do is nothing, since, more likely than not, if government does try to do something, it will do the wrong thing.
But what about after the bubble bursts? What government should do then? The most important thing is for government to not make things worse. One way government can make things worse is by bailing out those people whose irrationality and shortsightedness caused the bubble, and the bust, in the first place. If people get bailed out and don’t suffer at least some of the consequences of their mistakes, they won’t learn anything – or even worse, they will expect to get bailed out the next time, too. Then they will continue, and probably even increase, the risky behavior that caused the bubble and bust in the first place, which will make the next bubble even bigger and the next bust even worse.
The problem is that people want government to do something about the busts that follow the bubbles. But there is a fine line between not letting those who do dumb things escape the consequences of their behavior on the one hand and, on the other hand, trying to minimize the harmful effects of busts on the economy as a whole and trying to help those people who had nothing to do with the risky behaviors in the first place.
Unfortunately, the balance probably needs to come down more on the side of letting those who do risky things suffer the consequences of their actions. Otherwise, those who take irrational risks will continue to do so, and their actions will get riskier and riskier and the bubbles will get bigger and bigger, until finally a bust comes along that nobody can do anything about, a bust that will be so much worse because of all that government did before.
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For more information, see these articles by Martin Wolf (from the Financial Times), Amity Shlaes (on Bloomberg.com) and Robert Samuelson (from Newsweek).
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