What this covers
Daron Acemoglu and Russ Roberts examine the 2008 financial crisis and what it reveals about the limits of economic theory and policy. Rather than repudiating capitalism itself, Acemoglu argues, the crisis discredits two specific convictions that had overtaken economics: the belief that aggregate volatility had been conquered, and the assumption that markets function without institutional support. The conversation traces how the Great Moderation—a two-decade decline in business cycle volatility—bred overconfidence among economists and policymakers, enabling aggressive monetary policy and the underpricing of tail risk in an interconnected financial system. Both speakers inhabit the same intellectual space on one point: free markets and unregulated markets are not synonymous.
Acemoglu insists that markets rest on institutional foundations: property rights, contract enforcement, and regulation that improves information. Greed itself is morally neutral; institutions determine whether it drives innovation or degenerates into rent-seeking. The discussion ranges across credit rating agencies that misrepresented risk by stamping subprime mortgages as AAA-rated securities, the web-like structure of financial counterparties that transforms ordinary diversification into fragility, and the problem of limited liability that leaves principals insufficient incentive to curb excessive risk. A persistent tension runs through: while Acemoglu advocates for smart regulation modeled on FDA oversight, Roberts presses back on whether regulatory intervention itself creates perverse distortions and crowds out private trust mechanisms. Both agree that sacrificing long-run growth to smooth any single recession would be ruinous—a 1% sustained GDP decline over decades dwarfs even a severe contraction—but they spar over whether bailouts destroy market discipline or whether regulation inevitably produces unintended consequences that prove as dangerous as the problems it aims to solve.
Acemoglu argues the financial crisis discredits not capitalism but two overconfident notions economists held—that aggregate volatility had been conquered and that markets work without institutional foundations—while insisting that free markets are not the same as unregulated markets and that protecting long-run economic growth matters far more than smoothing any single recession.
- The 'Great Moderation' lulled economists and policymakers into hubris, leading to risky monetary policy and underpriced tail risk in a web-like financial system.
- Markets require institutions and smart (information-improving) regulation, not deregulation, but regulation always creates perverse 'seesaw' distortions.
- Sacrificing even 1% of GDP growth for decades dwarfs the cost of a recession, so policy should prioritize growth over short-term stabilization.
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Economic growth is overwhelmingly the most important issue: a sustained 1% lower annual GDP growth rate over ~30 years compounds to roughly 35% lower GDP, dwarfing the 3-4 percentage points of GDP lost in even a severe recession, so it would be a grave error to sacrifice long-run growth to smooth a business-cycle recession.
“if we sacrifice 1% of GDP growth for about 30 years that would be about 35% lower GDP in 30 years”
Modern finance and technology allow resources to move rapidly from declining firms/sectors to better opportunities without much unemployment, and let firms take bolder risks because idiosyncratic risk can be diversified—improving allocation—but this does not soften Schumpeterian creative destruction itself, only its aggregate destructive impact.
“it's still a creative destruction process as Schumpeter kind of envisaged it the good firms are going up and the bad firms are going down new technologies are replacing old technologies it's just that it's destructive effects are not being felt as strongly on the aggregate economy”
Sustained economic growth requires a particular political environment: stability, enforcement of property rights, rule of law, a society able to innovate and channel talent into productive activities, and the capacity to reallocate resources from declining low-productivity firms to high-growth ones—the essence of Schumpeterian creative destruction.
“economic growth we know requires a particular political environment that guarantees stability... enforcement of property rights a good kind of law and order rule of law environment”
Free markets were too quickly equated with unregulated markets; markets in fact rest on institutional foundations (property rights, contract enforcement, regulation of behavior and quality), and greed is neither good nor bad in the abstract—channeled by sound institutions it drives innovation and growth, but unchecked it degenerates into rent-seeking, corruption, and crime.
“we mistakenly equated free markets with unregulated markets... greed is neither good nor bad in the abstract... when unchecked by the appropriate institutions and regulations it will degenerate into rent-seeking corruption and crime”
America's economic success over the past 150-200 years (like Europe's) stems from channeling self-interest and ambition productively via institutional and social controls; the difference between a productive ambitious leader and a corrupt one like Suharto is not the ambition but the institutional checks that prevent those holding economic and political power from misusing it.
“there are a lot of ambitious people it's just a people with the same kind of ambitions they cannot do what Suharto does because our governors our presidents our senators our business leaders are generally checked there are a lot of institutional and social controls”
Political outcomes are often captured by a vocal organized minority that has solved its collective action problem, so even when a general majority would benefit from a policy like free trade, a concentrated protectionist group can prevail—explaining why protectionism, car-scrappage schemes, and Buy-American mandates gain traction despite being poor policy.
“the vocal minority who has actually been able to manage to solve their collective action problem and have some influential voice in the political arena... might actually get their way”
The political Coase theorem fails because political power, unlike economic exchange, lacks an underlying institutional structure that enforces deals: the party holding political power at any moment unilaterally controls enforcement and which payments/actions are allowed, and because political power is non-divisible and concentrated in one party, political bargains are far harder to strike than economic ones.
“the person who has the political power at the moment has the right and power to actually enforce the contracts and say who what type of payments will be made and what kind of actions are ok”
A dynamic financial system that diversifies idiosyncratic risk necessarily creates a web of counterparty contracts, and this web-like structure poses a new, underappreciated risk: if one set of counterparties fails, it makes the next set's obligations impossible, producing a domino effect—so diversifying ordinary risk increases the system's fragility to rare tail events.
“we've diversified a lot of regular risks but in the process we've created a greater fragility of the system to real tail events which involve enormous frightened non signal non-trivial fraction of the the central parties very linked parties in this web-like structure failing and creating a domino effect of counterparty risk”
There is a meaningful distinction between institutions (a rich concept including cultural norms and the political structure, where political actors uniquely can use force legally) and regulations (a particular narrower type of institutional arrangement), and the essay's lumping them together obscures that the deeper lesson may be the impossibility of removing risk via regulation.
“I would make a distinction which you do not make... between institutions and regulations you sort of lump them together... when I think of institutions... it includes cultural norms it includes the political structure”
The Long-Term Capital Management crisis was a 'warm-up' for the current bailout because the same problems—large leveraged positions whose smart but risky bets failed, prompting Fed intervention to prevent a domino effect—are central to both episodes.
“the long-term capital management... had very large positions in a variety of markets and when it's very smart but still risky bets did not work out... the Fed of New York and the Federal Reserve Board intervened and bailed out LTCM with the fear that... it would create a sort of domino effect”
Falling transaction and communication costs from technology, plus financial innovation, were the two indispensable pillars enabling global risk-sharing among less-correlated populations, but this same integration introduced the unappreciated counterparty risks.
“there are two pillars that actually are indispensable for this development one is technological innovations... then the second one is financial innovation”
Credit rating agencies represent a key regulatory failure: by transforming roughly $100 of high-risk subprime mortgages into about $80 of AAA-rated securities, they created the false impression that risky assets were riskless, and the proper fix is information-improving regulation rather than consumer-insulating bailouts.
“you took these bundle of extremely high risk subprime mortgages and out of that you created out of $100 of that you created an $80 worth of triple-a rated security”
Because limited liability means financial principals cannot be pushed below near-zero consumption (no negative consumption, jail, or torture), even severe wealth reduction leaves strong incentives to gamble, so private market discipline alone cannot deter excessive risk-taking—necessitating institutional checks analogous to political checks and balances on the powerful.
“there still is going to leave a lot of incentives for people to actually take Gamble's because there's a pretty severe limited liability constraint down there we're not going to take people looking to torture them we're not going to put them in jail”
The body politic is obsessed with creating a risk-free world (FDIC deposit guarantees, implicit then explicit guarantees of Fannie Mae's bonds), and this complex web of guarantees pushes economic activity into unregulated areas while making it impossible to constrain opportunism system-wide—suggesting the better lesson might be to make investors more aware of risk rather than constantly reassuring them.
“we're obsessed with giving people a risk-free world so we guarantee their deposits in FDIC banks... we guarantee the implicitly and it turned out to be explicit the loans and bonds purchased by Fannie Mae”
The real question is not whether a quality-assurance body like the FDA or credit rater is needed but whether it should be public or private; a private arbiter would likely emerge through economies of scale and have its own problems, and the mistake is assuming the public regulator would be perfect when it crowds out private trust mechanisms that would otherwise form.
“the real issue is not do we need an FDA or not it's whether such an organization should be private or public”
Bank capital requirements that forced many banks to hold only AAA-rated assets created a perverse incentive to manufacture more AAA-rated securities relative to more honestly-rated ones, illustrating that the interaction between multiple regulations makes the regulatory problem extremely difficult—removing one rule without replacing it can make other parts worse (a 'seesaw effect').
“many banks through regulatory requirements were forced to only hold triple-a which of course created a perverse incentive for more triple-a stuff relative to more honest stuff”
Just as the FDA—despite its distortions—is needed because patients and even doctors cannot assess long-term drug side effects, financial markets need a body that discloses risks and bars genuinely harmful products, so the right model for financial regulation is a leaner, more efficient FDA-like institution.
“for the drug market it's probably better that there is some body that says well here are the risks of this particular drugs take them knowing what the risks are”
The 'Great Moderation'—a marked decline in business cycle volatility from the mid-1970s until the recent crisis—led economists and pundits to wrongly conclude that aggregate volatility had become a non-issue, which was the wrong lesson to draw because the underlying fragility remained.
“the aggregate volatility has become largely a non-issue”
The conduct of monetary policy cannot be decoupled from beliefs about the economy's state; because policymakers believed aggregate volatility had vanished, they felt comfortable hailing Greenspan's aggressive post-2001 policy—a hubris that, had they feared big recessions more, would have made them far more hesitant and worried about asset/housing price run-ups.
“the conduct of monetary policy can also be not can cannot be entirely decoupled from our beliefs about the state of the economy”
Even brilliant, well-informed economists in policy roles are buffeted by political forces and can end up using their economics to justify politically-driven decisions; Bernanke, the foremost expert on the Great Depression, has struggled, and parts of the Bernanke-Paulson plan are hard to justify on pure economics—being smart and even wise is insufficient against political pressure.
“it's just very easy at the end of the day to kind of be influenced by the political forces and the political demands that are around you and end up with policies that then you then use your brilliant economics to justify”
Government bailouts of Bear Stearns, Lehman, and LTCM eliminated the lessons that decentralized markets and investors could otherwise have learned and acted upon—such as restructuring firms from publicly traded companies into partnerships so principals risk their own money rather than others'.
“any possible lessons that investors could have learned from this crisis and then institutions could have responded to those lessons by changing say the structure of these companies from being publicly traded to partnerships”
Standard market feedback loops failed to adequately punish financial principals: in LTCM, Bear Stearns, and Lehman the major players lost relative wealth (e.g. the Bear Stearns head fell from ~$120M to ~$10M) but still went home wealthy, and investment banks reportedly paid over $20 billion in non-stock bonuses, so the deterrent of severe punishment that principal-agent theory requires was largely absent.
“the investment banks this year are estimated to have paid over 20 billion dollars of non stock bonuses so this is not really looking like a an example of great punishment for the people who are in the middle of of the fray”
The current policy moment carries three political-economy risks: protectionism (the same wrong policy as the 1930s), over-regulation that erects entry barriers and stifles the reallocation/innovation engine of growth, and a broader backlash that wrongly blames free markets for what were really regulatory problems and pushes toward a government-commanded mixed economy.
“protectionism it always kind of riles up people... exactly the the wrong type of policies the United States adopted in the 1930s”
In the run-up to the crisis, monetary policy departed from the prudent pattern of the prior 20-25 years; Greenspan drove short-term rates to historic lows from 2001-2004 and dramatically narrowed the spread between short and long rates, and had he not done so many of the resulting problems would have been smaller or less dramatic.
“Alan Greenspan from 2001 to 2003 or four took interest rates much much lower than they had been before certain to historic lows... one could argue... had he not done that all of these many of these problems would have been either small or or less less dramatic”
The economics profession is particularly successful precisely because it abstracts away from certain complications, then revisits and spotlights mechanisms that turn out to matter more than initially assumed—here, the counterparty-web risk that had been abstracted away.
“economics is particularly successful because we are good at kind of abstracting away from certain aspects of these complications and then as we recognize some of the complications... we go back and put the spotlight on these new mechanisms”
Anyone who claims to know the answer about how the stimulus plan will play out is being overly optimistic, given the deep uncertainty among even Nobel-laureate economists like Krugman and Becker who agree on little.
“anybody who says they know the answer I think they're being a little optimistic”
Bernie Madoff is an exception to the pattern of financial losers because his conduct was so blatantly criminal and public that it falls outside the scope of ordinary risk-taking failures within Wall Street culture.
“Bernie Madoff is the exception... that's so blatantly criminal arrest so public that that kind of goes outside the scope of this”
Despite disagreements, the Obama administration has assembled a first-rate economic team (Larry Summers, Austan Goolsbee, Christy Romer) of high IQ and knowledge, so policymaking has not been delegated to economically illiterate lawyers—though deep uncertainty remains about whether the stimulus will create jobs or merely too much debt.
“Obama has put together a first-rate economic team in terms of IQ and knowledge... Larry Summers Austan Goolsbee Christy Romer I mean these are all excellent people”