No one is enthusiastic about these actions, but to the extent that the alternative was a financial breakdown like that which occurred in the 1930s, measures along these lines were difficult to avoid. Some of the policy responses included injecting large sums of taxpayer money into the financial system. Treasury Department and the Federal Reserve played an active role in attempting to mitigate the effects of the crisis.
The recent financial and economic crisis has led many to question the presumption in favor of private markets. This Economic Letter examines an important instance where the requisite assumption appears not to be satisfied. Of course, these arguments require assumptions, and the question is to what extent these assumptions are satisfied in the real world. Economists have provided a range of formal arguments to support this conclusion. To varying degrees, most economists believe that economies perform better when markets are run largely independently of government than they do when government plays a dominant role. Financial regulators may be able to enforce changes in compensation that would attenuate these adverse effects. Convex compensation packages give financial executives incentive to adopt risky investment projects, implement highly levered capital structures, and create new risk. Financial executive pay is a convex function of profits if recipients get a greater increment in pay when returns are high as opposed to moderate, compared with when returns are moderate as opposed to low.
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