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  Widespread ownership could help solve the agency problems inherent to organized labor. In the private sector, labor interests can obtain representation through ownership in conjunction with other stakeholders, such as shareholders and creditors. Organized union leadership could assist with coordinating stakeholders' interests, helping to solve collective action problems, while mitigating the short-term conflict between capital and labor interests. In effect, workers should become shareholders. This is a role that, to date, union organizations have eschewed. (We shall see how General Motors evolves with its large ownership position granted to the UAW.)

  In the public sector we are witnessing a serious agency failure in labor organization and bargaining. Many state government budgets are being busted by wages, pensions, and healthcare benefits that have been promised to public employees under union contracts. Because the politicians who granted these benefits relied on public union dues for campaign donations, they had a strong incentive to comply with union demands. We can see the inherent conflict of interest here. The taxpayer is on the hook to pay off these liabilities, yet their agents—their elected politicians—abrogated their responsibilities to their constituents in order to get re-elected. The taxpayers had no real representation at the bargaining table when these labor contracts were negotiated. Unlike private unions, there is no real ownership stake available in the public goods sector, so it is likely these unions will eventually be regulated like public utilities, where contracts are determined by a political board accountable to voters. In this conflict, public unions have fixated on collective bargaining rights. But bargaining with whom? The taxpayer?

  This brings us to the most pressing regulatory policy issue of our day—the principal-agent failures in financial markets. The financial industry is different from other sectors of the market because banks and shadow-banks are the only private institutions in the economy that have the ability to create money through credit. This privileged function means the financial sector has a significant impact on the macroeconomy through the very price of credit—the interest rate. Our model explains how interest rates are the most important signals that tell us how to balance our economic decisions over time. If these signals can be heavily distorted by the decisions of private agents, it becomes apparent that the incentives these agents face are a crucial policy issue. It is also why financial regulatory reform is such a contentious issue.

  Most financial services are administered by agents acting for principals. This applies to bankers, investment bankers, fund managers, brokers, traders, etc. The potential for abuse is considerable because of the deliberate complexity and lack of transparency in financial transactions. Many books, some of them quite fair and balanced, have been written assigning blame for the recent financial crisis to various actors within the financial community, from mortgage lenders to commercial and investment bankers, to ratings agencies and dealers in financial derivatives.[64] The initial political reflex has been more laws, more regulation, more regulators, and more political oversight. Apparently, given the calamitous results, it is taken for granted that a self-regulating market was not enough.

  Many critics of financial policy take aim at the conflict of interest between investment banking and commercial banking that was regulated by the Glass-Steagall Act from 1933, until it was repealed by the Financial Services Modernization Act of 1999. In essence, commercial banks receive deposits guaranteed by the federal government and make loans to business, while investment banks provide capital to business and also trade in a variety of speculative instruments. Mixing these two functions in the same firm, such as Citigroup, has led to conflicts of interest between the banks' customers and the banks' own speculative trading activities. In addition, risks undertaken in the banks’ loan and proprietary trading portfolios were essentially underwritten by the insurance guarantees of the Federal Deposit Insurance Corporation and, ultimately, the Federal Reserve as lender of last resort to member banks. Glass-Steagall separated investment banks from commercial banks and the reason given for its repeal was that such regulation did not apply to foreign banking conglomerates. Thus, U.S. banking conglomerates were competitively disadvantaged in international capital markets, as foreign banks conducting both functions grew more profitable. Unfortunately, the outcome of combining commercial and investment banking led to excessive risk-taking that, when the crisis hit, threatened the solvency of the worldwide commercial banking industry. An obvious solution would be to reinstate Glass-Steagall regulation, but that is unlikely because the same anti-competitive results will recur.

  The case for direct regulation with laws and monitoring can be overstated. The financial sector is already one of the most regulated industries in the world—Citigroup alone has over 100 regulators in the United States and over 400 worldwide, yet Citigroup was at the heart of the financial maelstrom. Increasing the number of regulatory agents is also costly and introduces greater potential for manipulation through regulatory capture.[65] Competition in financial markets is ruthlessly aggressive and innovative. Most egregious misconduct is controlled by this competition (it was not the Securities and Exchange Commission that uncovered the Bernie Madoff scandal, but a competing financial analyst). Given the questionable success of direct regulation, perhaps we should think outside the box by carefully considering the incentives financial agents face and how best to influence these incentives.

  As a matter of policy, we should try to encourage financial innovation toward the goal of more prudent and effective risk management. This was the promise of securitization and financial derivatives that went awry. An obvious policy solution to control aberrant agent behavior in finance is greater transparency and rules of disclosure. But there is also a serious incentive problem that prevails in the financial industry that encourages agents to take outsized risks of the ‘heads I win, tails you lose’ variety. This incentive stems from the fact that financial risks are often taken on credit, or borrowed money—what the industry cynically calls OPM for Other People’s Money.

  The systemic risk arose when this perverse incentive received an added guarantee from the Federal Reserve. Fed policy under the Greenspan era was noted for massive injections of liquidity whenever a financial crisis threatened. It started with the stock market crash in 1987 and continued through the 1990s with the Mexican debt crisis of 1994, the Asian currency crisis of 1996, the Russian default of 1998, the Y2K scare, and the dotcom bust of 2000. Financial institutions and their traders learned all the wrong lessons from this liquidity policy they sardonically referred to as the “Greenspan put.”[66]

  It is likely we need some forms of reregulation and federal oversight on large commercial banks, but the wrong regulation can often be more costly than no regulation. The more effective cure may be the discipline of financial ruin. We should let banks and non-banks compete internationally, but only under a strict Federal Reserve policy stating that failed banks will be reorganized and restructured under federal bankruptcy laws. We need the discipline of bankruptcy and the consequence of losses to control moral hazard, while still allowing and encouraging financial innovation. This applies even more forcefully to the shadow banking system. This is the lesson we probably missed sending with the 2008 TARP bailouts and the backstop of quantitative easing.[67] Our financial reform efforts will spawn dangerous new moral hazards if we designate certain institutions as “too big to fail.” As for exotic financial derivatives, establishing formal securities market exchanges that impose trading rules and regulations on these new untested, but widely marketed, financial instruments may be necessary.

  However, the true problems of our financial sector harken back to a configuration of policies that favor financial interests through credit creation and debt leverage, allowing the tail of finance to wag the dog of the real economy. Between 1980 and 2000, financial industry profits rose from $32.4 billion to $195.8 billion and the industry’s share of all U.S. profits went from 19% to 29%. By 2006 it was $427 billion and 32%. This is not to condemn fina
nce unequivocally, as an open financial market operating according to objective rules is one of the most effective democratizing tools available in the world today. Finance has empowered developing country populations at an astounding rate, so the regulation of these markets has become a critical challenge. But financial and monetary policy has trumped sound economic principles and this is where our current problems lie. No financial system that operates under distorted incentive structures will find stability. Lending money was meant to be a slow, boring, incremental business. Unfortunately, changing technology and our own misguided and outdated policies have turned investment finance into the casino it is today. Only better-informed policies can turn it back.

  Conclusion

  One is hard-pressed to end this discussion, as it seems we have only scratched the surface of so many policy challenges. The format of this citizen-voter’s guide to the economic complexity of our modern world aspires to provide a telescopic “big picture” perspective that offers more clarity than confusion. Hopefully, my exposition has convinced you that economics is a bit more understandable than you have been led to believe. This should not lead us to conclude that the controversies that plague economic science and the formulation of policy are easily settled, or that this guide provides any incontrovertible truth. Though beautiful, the world is a messy place, which is one of the things that makes it so fascinating. We should expect it to continue to be messy.

  Let us conclude by summarizing nine basic lessons outlined in this guide:

  1. Uncertainty is the defining characteristic of our changing world.

  2. Loss aversion is the primary motivation determining human behavior.

  3. Economic decisions revolve around inter-temporal consumption preferences, subject to the prior constraints of loss aversion.

  4. The “interest rate” balances the future against the present.

  5. All progress entails risk-taking; reward does not come without risk.

  6. Managing the risk and rewards of change is the key political goal of a free, democratic society.

  7. Our financial system is overly dependent on credit creation and debt.

  8. Debt increases and concentrates risk.

  9. Current macroeconomic models do not address distributional failures such as economic inequality.

  We can separate these nine lessons into logical analytical categories, where the first six elucidate the basic laws of economics, irrespective of time or place. The next two pertain to specific financial policies enacted over the past century. The last lesson advocates a new direction for the future.

  You might ask, after all this discussion, how exactly do we explain the financial crisis of 2008? Answering this question has not been the primary intent of this guide. Rather the attempt has been to impart the necessary knowledge and tools for the reader to develop the answer on his or her own. We have lots of villains: investment bankers and their traders, mortgage lenders, ratings agencies, government subsidies of the housing sector, government-sponsored enterprises like Fannie Mae and Freddie Mac, monetary authorities, politicians, home buyers everywhere; the list goes on. Some will regard this mess with disdain and say that it’s all explained by human greed and selfishness. But this misses the point. Greed, or perhaps more accurately, self-interest, is an aspect of human nature. It is a constant in this regard and cannot fully explain any change in outcomes. Instead, we should identify the contextual factors that constrain greed, and promote ethical behavior and cooperation. The root cause of our financial crisis was the perversion of economic and financial incentives that all the above-mentioned actors faced, which started at the top with the decisions of the Federal Reserve. At heart, the crisis was a policy failure of calamitous proportions.

  This guide has focused on the basic logic and practice of economic policy in order to understand this failure in all its dimensions. I have argued that the defining characteristic of our world is uncertainty and its associated risks. Uncertainty is the nature of a universe in flux and risk is our innate perception of how change prejudices our well-being and chances of survival. These two concepts shape our attempts to manage, through deliberate action, the unpredictability of the future.[68]

  These actions include a variety of private and communal, or public, efforts. At the individual level, our desire to manage change has led to the evolution of private exchange markets whereby we seek gains, manage risks, and adapt to change. The creation of these private markets long predate established public economic institutions. Where private markets have failed, public institutions have attempted to fill the void. This public effort should be guided by the goal of managing the risks of change through the coordination and complementarity between private markets and public institutions. My public policy argument flows from these basic postulates.

  Risks associated with uncertainty are managed through diversification, which can be realized through three complementary strategies: self-insurance, private insurance pooling, and social insurance pooling. Self-insurance requires the accumulation of real and financial assets and their diversification across asset classes. Private insurance requires a competitive market guided by accurate information, appropriate incentives, and accurate price signals—all of which minimize moral hazard and maximize the efficient provision of benefits. As a last resort, social insurance is inherently less efficient by design, but necessary where self-insurance and private insurance markets are incomplete. Examples of social risk management include unemployment insurance, disaster relief, and welfare transfers.

  The three complementary strategies to manage risk require an institutional structure that ensures open and transparent competitive private markets. The requisites include appropriate rules, regulations, and practices that defend the rights of ownership and control over all real and financial assets. This is especially critical to the functioning of public corporations, the banking system, and the financial industry. To ensure our economic well-being, voters faced with various policy choices must understand the logic of private markets.

  Many critics of democratic capitalism crusade against “free-market ideology.” They claim that there are no “free markets” and that the abstraction is a chimera; a clever propaganda serving powerful private interests. These critics construct a straw man of “free market” purity only to disprove it with evidence of widespread market abuse. But this is a mere Sophist exercise. All markets are subject to rules of engagement in the marketplace. While purely free markets may be a theoretical abstraction, that fact does not diminish their heuristic or practical value. Theory is the lodestar that orients our practical policy decisions.

  Free exchange markets are highly useful tools to create wealth, advance individual freedom, build trust, create social cohesion, and support pluralistic participatory democracy. They depend upon billions of human decisions interacting in a global “neural” network. As such, they are little more than amoral exchange networks that operate according to the freely expressed choices, or preferences, of these billions of decision makers. In this sense, markets are merely mechanisms for exercising social choice. This is just like democracy, which is a political exchange “market,” where outcomes are determined by casting votes. Of course, these choices or preferences are not always socially optimal, and markets can, and do, fail. Economic markets can often reinforce the existing power relationships in a democratic society. But ultimately, markets are valued because they provide feedback information in the form of price and quantity signals. These signals guide us as we make judgments about optimality and, together with openness and transparency, even about what is morally just and what is not. Functioning competitive markets aid us in our goal of creating a better society, not only a materially superior one, but one that is also more just and fair.

  Markets themselves are merely the means to an end. Some of us wish to get rich, some to be free of material worries, others wish to create a legacy, or to enjoy leisure and social enrichment. The ends we choose are as infinite as our numbers. From a soci
al point of view, this becomes a philosophical and moral discussion about how one envisions the “good society.” In the social sciences and humanities these are referred to as normative issues to differentiate them from positive arguments based on empirical evidence. Another way of looking at the difference is that normative issues are framed as what should be, while positive issues are what is. Science deals with the real world, while philosophy ventures into the abstract.

  The normative debate has not changed that much since the days of Socrates, Plato and Aristotle, though it is still worth engaging. But as a practical matter, the Founding Fathers did tackle these philosophical questions and codified their guidelines in the US Constitution. To reiterate, the Declaration of Independence tasked our government to guarantee its citizens’ unalienable rights of life, liberty and the pursuit of happiness. This history argues that the primary objective of policy must be to ensure that people have freedom of choice and freedom of action to realize their individual preferences, subject to certain constraints of law and negative liberties.[69] Open, competitive markets are the most efficient mechanisms for achieving this objective. But markets are not free, efficient, or fair unless citizens are constantly vigilant. Human judgments are critical to maintaining the functioning markets that help us realize just and efficient outcomes.

  Let us be clear on market intervention: the critical application of policy judgments is not over final outcomes, but over the conditions or rules under which those outcomes obtain. Sometimes a bad outcome is nothing more than bad luck. This is regrettable, but it’s not a failure of the market. The policy issue regarding markets comes down to diminishing market distortions while enhancing market perfections.

  A market distortion is one that impedes our freedom to pursue our economic goals, while a market perfection is one that enhances that quest.[70] I think we can agree that a stable and sustainable growing economy is an intermediate policy goal that enhances our individual preferences for personal freedom and economic security. We have examined some of the necessary conditions for a sustainable capitalist market economy. To obtain these conditions, we need an accurate understanding of economic behavior and the ways in which different incentives influence that behavior. Our model illustrates how we make economic decisions that determine our levels of consumption and saving, investment and production. For these decisions to be fluid and optimal, we need accurate prices, especially concerning the value of our money, or currency. We also need an accurate price for our time value of that money, which is the interest rate. These two prices are the most important from a policy standpoint. They are directly influenced in the short term by monetary policy through the banking system, and are determined in the long term by population demographics, technology, and competitive policies in the international economy.