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Do no harm

Gonzalo Fernández de Córdoba and Timothy Kehoe have weighed in on the crisis. You can read the paper here. A lot of their analysis is based on Professor Kehoe’s work with Edward Prescott on great depressions (you can get the book here). To summarize their opinions on great depressions in general, they say:

Kehoe and Prescott conclude that bad government policies are responsible for causing great depressions. In particular, they hypothesize that, while different sorts of shocks can lead to ordinary business cycle downturns, overreaction by the government can prolong and deepen the downturn, turning it into a depression.

What would be an overreaction by the government? They go on further to say:

With banks and other financial institutions in crisis, the government needs to focus on providing liquidity so that banks can provide credit at market interest rates, and using the market mechanism, to productive firms. Unproductive firms need to die. This is as true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity. These firms absorb labor and capital that are better used by productive firms. The market makes better decisions than does the government on which firms should survive and which should die.

What should we do instead of bailing out firms? In my opinion, we need to focus on the human side. For instance, let’s spend money to make sure we don’t have a generation of malnourished and undereducated children.

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