In this Article, I focus on the economics of financial markets and regulation rather than the broader philosophical inquiry of a companion article, and I narrow the competing positions to libertarianism and liberalism. I take more of an historical approach, following the development of Austrian and Keynesian theories of the business cycle from their origins in the 1930s to today. I consider the details of recent financial regulation less than in the companion article, but I consider financial regulation in tandem with monetary and fiscal policy more than in that article. Considering financial regulation along with monetary and fiscal policy is a worthwhile move. Each of these three types of interventions can help both to dampen inflationary booms and also to shorten and ease recessionary busts. Thus, to some extent, the three types of policies are substitutes. The optimal level for each depends in part upon what is happening with the other two.
Part II of this Article categorizes approaches to governmental interventions to stabilize the markets into four types. The categorization is based on two distinctions. One distinction is between libertarians, who greatly distrust government and advocate at most very limited interventions, and liberals, who distrust the volatility of financial markets and advocate more extensive interventions. The other distinction focuses on the source of distrust of markets or governments. Distrust may emphasize problems of greed or of ignorance. As I note, a distinctive and welcome characteristic of the Austrian and Keynesian theories is that they focus more on ignorance than on greed.
Part III begins the analysis of Austrian and Keynesian theories of the business cycle, describing some important similarities as well as differences. Each focuses on the importance of investor expectations in making investment decisions in the face of deep uncertainty. Both see investors regularly becoming involved in speculative booms in which optimistic expectations of future profits lead to overly high levels of capital investment. But the theories differ in their analysis of the source of these expectations. Austrians blame central bank monetary policy, while Keynesians see them as the result of high animal spirits following a period of relative calm and prosperity. Both theories agree that after a while such booms become unsustainable. Eventually expectations shift, and a contraction begins. The contraction can be long and painful, especially as banks, businesses, and households must unwind the large amounts of debt incurred during the boom. The two theories characteristically differ, though, as to the wisdom of governmental intervention to try to lessen the severity and length of the contraction.
Part IV considers developments in the Austrian approach. Contained within the heart of the theory is a recognition of the potential instability of financial markets, which creates serious tension with the strongly libertarian commitments of the approach. I identify four strains of responses within the approach: Panglossian, antifractional reserve banking, pessimistic, and cowardly interventionist. The first downplays the seriousness of market instability, not very plausibly. The second recognizes the seriousness of market instability, but prescribes a ban on fractional reserve banking—a highly implausible policy. The third also recognizes the seriousness of market instability, but is so pessimistic about the likely effects of governmental intervention that it recommends living even with very severe periodic depressions rather than trying to stabilize markets. The fourth is more pragmatic, and allows that a moderate amount of intervention in the form of monetary, fiscal, and financial regulatory policy is appropriate. This fourth response fits within what I call cowardly interventionism, though it tends to the more cowardly side of the spectrum.
Part V considers developments in the Keynesian and related liberal approaches. That theory highlights deeper problems within financial markets than the Austrian theory typically recognizes and, hence, favors greater governmental intervention. Yet further reflection upon both the cognitive limits of governmental actors and also the political pressures they are likely to face, in light of historical experience during the postwar years, suggests deep problems for governmental interventions. In re-sponse, some liberals rather naively call for politicians and bureaucrats to do a better, more intelligent and honest, job. Others call for quite extensive financial rules to try to limit the influence of the financial sector. But another response takes the limits on governmental action very seriously, and, as a result, advocates more limited intervention than other liberals would like. This response fits within what I call cowardly interventionism, though it tends to the more interventionist side of the spectrum.
Part VI provides more description of what cowardly interventions within monetary policy, fiscal policy, and financial regulation look like. This includes discussion of tensions that still exist within each policy area between those who approach cowardly interventions from the libertarian end and those who approach from the liberal end. On balance, the actions taken during the crisis and the regulation imposed after the worst of the crisis look like sensible cowardly interventions, although certainly plenty of mistakes were made.
Brett H. McDonnell, Of Mises and Min(sky): Libertarian and Liberal Responses to Financial Crises Past and Present, 34 SEATTLE U. L. REV. 1279 (2011).