At the end of his introductory essay, Liaquat Ahamed asks two questions. One is:

...has the structure of the economy changed so much ... that the traditional instruments of policy we thought we could rely on to jumpstart the economy will no longer work?

New approaches are required, but it's not so much the nature of the economy that has changed, it's that we forgot or never fully learned the lessons of the Great Depression.

One of the lessons of the Great Depression should have been that the financial authorities need to monitor and regulate excessive build-ups of systemic risk. In addition, once a crash occurs and fear is one of the main factors that is causing markets to freeze up, financial authorities need to know how to quickly reduce risk - they need some means of removing the questionable assets from the market place - and this must be done in a politically palatable, least cost manner.

The Fed can manage risk in two ways, through regulation and through the buying and selling of financial assets. For example, the Fed can use regulation to prevent firms from holding some types of risky assets, or to limit the amounts they can hold, and it can use things such as margin requirements to help to control leverage. Through open market operations, the Fed can trade safe assets such as Treasury Bills for risky assets, and in the process change the proportion of risky to non-risky assets held on the balance sheets of the public and private sectors.

I think policymakers failed on two counts. First, they did not monitor and warn us of the risk we faced prior to the collapse of the bubble, and they certainly made no effort to reduce the size of the risk we faced to the extent they did identify it (in fact, Greenspan argued that we shouldn't do anything when we suspect risk is rising, that we shouldn't try to pop a financial bubble even if we are pretty sure we know one exists). Second, financial authorities at the Treasury and the Fed, the Treasury in particular, were caught largely off-guard when the crisis hit and that forced them to invent things as they went along in what looked from its execution like a mostly trial and error approach to solving the crisis, even in the cases where the response was based upon solid underpinnings.

In order to prevent this from happening again, financial authorities need to learn the lesson of the Great Depression, and of this crisis, and be much more aggressive at monitoring and regulating risk in the financial sector. And, in the event that collapse happens despite their best efforts, they need to have plans on the shelf, ready to go, plans that have been pre-approved by the appropriate political and policy authorities. It is also important for everyone to understand and believe that the plans will be executed without hesitation or delay if the financial sector gets into trouble, and that requires that the plans be credible.

Better risk management is not the only shortcoming that has been revealed by the response to this crisis, the response of policymakers has made it clear, for example, that we need a reliable test of solvency and a plan for the orderly dissolution of firms that are deemed unable to meet their obligations. But if we had monitored and regulated risk more effectively prior to the crisis, and been more ready when and if the crisis hit anyway, then perhaps the need for orderly dissolution of failing institutions would not be so large.

[I'll continue with Liaquat's second question on international economic leadership in my next post, but the basic message will be that we are in a situation where we are big enough to break the world economy, but not big enough to fix it on our own. Hence, cooperation in response to economic crises is essential now, and will continue to be essential in the future.]