[HT: Simon Johnson] MIT’s Daron Acemoglu has written one of the best essays on the financial crisis and what it means for economics that I have read. He argues, convincingly, that forgetting about what drives economic growth when formulating policy is a big mistake. Importantly, it has been all too easy to forget about how important institutions are in advanced economies as we trotted along with seeming economic prosperity for a decade.

The same economic and financial changes that have made our economy more diversified and individuals firms better insured have also increased the interconnections among them. Since the only way diversification of idiosyncratic risks can happen is by sharing these risks among many companies and individuals, better diversification also creates a multitude of counter-party relationships. Such interconnections make the economic system more robust against small shocks because new financial products successfully diversify a wide range of idiosyncratic risks and reduce business failures. But they also make the economy more vulnerable to certain low-probability, ‘tail’ events precisely because the interconnections that are an inevitable precipitate of the greater diversification create potential domino effects among financial institutions, companies and households. In this light, perhaps we should not find it surprising that years of economic calm can be followed by tumultuous times and notable volatility.

Acemoglu also warns against the twin dangers in reactive policy. First, there is some necessarily reallocation that lies at the heart of the crisis and many bailout policies are halted that process. Second, that there is a danger this may reinforce views that the market is working for the privileged. Both of these will undermine moves towards a sensible regulated market outcome in the future.

I can’t do justice to the essay in this post but I commend it to anyone who is thinking about the long-term policy ramifications of the current mess.

5:30:40 PM