In the aftermath of the financial crisis, the debate in Washington continues to be the same as it has been for longer than I have been alive. On the right, Republican ideologues argue that the role of government in industry should be limited and that freer markets unburdened by excessive taxation are best way to grow the economy; on the left, Democrats argue that increased government regulation, overisght, and spending programs are neccessary to promote social and economic justice and help grow the economy. It is my contention that this conventional debate entirely misses the point. The root cause of the financial crisis was not a lack of complex rules and regulations and the failure of the Bush tax cuts prove empirically that reducing taxes is not a sure path to real (inflation-adjusted) economic growth. Instead, the problem is a larger and simpler one of misaligned incentives, and the key market failure was that people were able to extract private gains while distributing enormous losses throughout the larger ecosystem. This is just a very extreme example of an externality problem. And it has a solution.
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