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Government Intervention in the Economy During a Financial Crisis

When is it a good idea for the government to intervene, or withhold intervention, in an economic crisis? Professor Julia Mahoney explains that it is crucial for the government to uphold clear and regular legal rules and to ensure adequate liquidity for the market to function. However, if the government starts inventing new rules or circumventing the regular rules, this causes confusion and damage to the economy. https://youtube.com/watch?v=xlitBwWTp2g


Government action is both essential for, but also potentially detrimental to, management of financial crises and helping the economy recover from severe downturns. Government activity is essential in the sense that a functioning court system and clear legal rules will enable private actors to take the actions that they need to take in order to get the economy back on track. On the other hand, government actions that create uncertainty, or that exacerbate anxiety can have the opposite effect. Now, it's hard to know exactly what sorts of government actions can be helpful and what government actions are going to harm. But there are a few things that we can say, I think, with at least with some continence. First, in societies that have central banks as the United States does, because of course we have the Federal Reserve, one of the functions of government in a financial crisis is for that central bank to lend freely to solvent institutions, perhaps at a penalty rate, but to lend freely. In other words, for the government to ensure through its central bank that the system has adequate liquidity. Financial crises can be thought of as, in effect, the seizing up of a financial engine when it begins to stall. Once it begins to stall, there can be contagion as other players in the economy get worried about their own access to money, and therefore begin to hoard it. What the government can do in ensuring liquidity is to give confidence that there isn't going to be any kind of problem with the flow of money and credit. However, when government takes action that changes the rules, then things become, I believe, more complicated. For example, when the government bails out firms, or is seen to be bailing out firms that under existing law, and in the normal course of events, would not survive because they have not been managed carefully, or because they've been unlucky. At that point, government action, I think, becomes a lot more ambiguous. In the case of Dodd Frank, Dodd Frank enacted not a lot of new restrictions, but in effect created a framework pursuant to which regulators were supposed to impose a whole lot of new regulations. A lot of those who were making decisions to invest or not invest, were not sure what it was those regulations that were to be promulgated under Dodd Frank looked like. There were similar concerns with the Affordable Care Act passed in 2010. What were those regulations to be? And in the meantime, was it a good idea to invest in a particular entity that was involved in healthcare at a particular price? Was it a good idea to start a company, for example, to be involved in something that might be affected by these regulations that were, as yet, unwritten? Those sorts of government actions may inhibit recovery by creating uncertainty. But, I wish to emphasize, we can only make educated guesses about what sorts of government action might actually be detrimental to an economic recovery.

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