While I think there is value in the high-level discussions of what caused the financial mess and ensuing economic contraction, not enough attention has been given to the specifics. While I agree with those who point the finger at government policies (see previous blog entry), I also agree that the market economy does experience swings. These are not necessarily bad, but smoothing them out a bit is probably good -- making economic coordination easier and reducing the costs of misallocated resources.
I don’t mean heavy-handed government intervention that acts in a way that prevents the circuit breaker from blowing. On the contrary, many of the most important ways of moderating the swings consist of removing and preventing government interventions of the kinds I listed in my previous entry.
More relevant are means of helping us learn more quickly, thereby reducing the magnitude of the problems resulting from failure. Designing institutions and learning processes to learn from “fast failure” through many modest experiments (as well as developing better means of anticipation) seems to be a promising approach. This is really just a practical implementation of pancritical rationalism, and was nicely described in some detail by Stefan H. Thomke in his book Experimentation Matters.
We won’t really make major progress in moderating the business cycle until we can find better ways of reducing the endemic biases in human thinking. We also need to continue improving our understanding of feedback systems and problems resulting from imitative behavior. (Imitation may be why all major mortgage debt rating agencies used the same flawed ratings models for poorly-understood derivatives, though that may have more to do with SEC regulations.)
One factor that no doubt contributed to the problems is the way executive compensation has been incentivizing executives to take on excessive risk in pursuit of short-term gains. That is not inherent in the market system; it's a result of the specific compensation schemes used. Four authors have recently published a working paper suggesting a better compensation scheme. My review of “Dynamic Incentive Accounts” is here.