The recent collapse of financial giants Lehman and AIG have led to new calls for regulation. Nobel Prize winning economist Joseph Stiglitz has proposed a six point plan to deal with the current financial situation. He believes that the government needs to “correct the incentives for executives” by requiring that bonuses be paid on five year returns, rather than on annual returns. We need a “financial products safety commission”. We need a “financial systems stability commission” to overview the entire financial system. We need to impose regulations like “speed bumps” to limit excessive lending. We need regulation to limit predatory lending. Finally, we need better competition laws. Firms that are “too big to fail” ought to be broken up.

Absent from this list are any calls for reforming the Federal agencies that currently exist. Professor Stiglitz insists that “financial institutions are at the center of blame”. Stiglitz does admit that the Fed mismanaged policy, but makes no mention of other authorities. The Federal Reserve created this problem with “a flood of liquidity” that caused a “housing bubble” and low household savings. These are interesting observations. The idea that inflationary monetary policy should cause an investment boom in housing and dearth of household savings (i.e. a consumption boom) that leads to a crash is highly consistent with the explanation of business cycles that earned Friedrich Hayek his Nobel Prize in economics. Professor Stiglitz is hinting at Austrian Business Cycle Theory.

Unfortunately, professor Stiglitz has learned the wrong lessons from this experience. He has jumped to the conclusion that private markets and “lax regulation” are to blame. While it is surely the case that private investors and CEO’s have committed errors, it could hardly be the case that Federal Regulators are blameless. At a minimum, Federal authorities failed to prevent the current crisis. Professor Stiglitz does note that “the ingenuity of those in financial markets means that regulations will be circumvented. Indeed, he admits that past regulations came to be ineffective, and uses this as an excuse for more regulation. This supports the theory of regulation advanced by Ludwig von Mises in his 1940 book on Interventionism. Regulations lead to unforeseen and unintended consequences that require more regulation, if we insist upon governmental controls instead of regulation by true competition.

The current crisis should be viewed as a failure of several large organizations, only some of which are private. The difference between private failure and public failure is that, as Milton Friedman put it, “If you start a program that is a failure and you are in the private market, the only way you can keep it going is by digging into your own pocket. That is your bottom line. However, if you are in the government, you have another recourse. With perfectly good intentions and good will nobody likes to say “I was wrong” you can say, “Oh, the only reason it is a failure is because we haven’t done enough”. This crisis is shutting down some private firms, like AIG, yet culpable public sector organizations will continue their operations, perhaps without any reforms at all. We may also get more of these public regulatory organizations. This is the true failure of a system, failure to reform itself. Capitalism reforms itself through bankruptcy, but government has no such automatic mechanism for change and reform. ON the contrary, public institutions use crises as justifications for their expansion, even where these public institutions are at least partly to blame for the crisis in question. We can, however, learn from the recent crisis by putting it in the proper perspective. Mises and Hayek arrived at the right answers largely because they thought about capitalism and government in evolutionary terms. We can arrive at the rights answers to the problems of our time by thinking about them in the same way.