THE CRISIS OF 2008: LESSONS FOR AND FROM ECONOMICS

The financial crisis is, in part, an embarrassment for economic theory. Economists tended to think that severe business cycles had been conquered; that free markets require no regulations to constrain self-interest; and that large, established companies could be trusted to monitor their own behavior so as to preserve their reputational capital. These three beliefs have proved to be inaccurate. On the other hand, economists justifiably believe that as a process of creative destruction, capitalism requires institutions that allow for innovation and the reallocation of resources toward firms that have successfully innovated. This suggests that we should not condemn wholesale even the financial innovations that played a role in the crisis, which have been remarkably productive and will continue to be, given the right regulations. Nor should economists hesitate to say that political reactions to the crisis that hamper such innovation and reallocation may do far more harm than good.