The classic trading system of exchange is identified with David Ricardo, the early nineteenth-century economist who first analytically clarified it.

As practiced today, Ricardo's classic system results in win-win exchanges when both trading partners are either (1) industrialized nations with modern impulse/check/balance governments, no excessive unemployment, and reasonably effective control of corporate abuses or (2) less-developed nations roughly equal in power and with some control of corporate abuses. Unfortunately, much of today's international trade does not meet these conditions.

You can show very elegantly that the market will efficiently price two-quart botttles of ketchup at twice the price of a one-quart bottle; the problem is that the one-quart bottle may be mispriced.

The economist Hyman Minsky has reminded us, “Each state nurtures forces that lead to its own destruction.” All of history testifies to the truth of this observation. Greater liquidity leads firms to borrow more than before. But higher levels of debt mean increasing vulnerability to adversity and negative shocks in an ever-changing world. For these reasons, as Minsky put it, stability leads inevitably to instability.

Markets can and do allocate resources efficiently, of course. But only under appropriate conditions—when there is lots of competition and information, for instance, and when people can make individually rational choices. Many market-solutions-for-everything advocates seem to have overlooked the point that such conditions don’t always exist.

The important thing is that over time, scientific progress transforms things that used to have to be dealt with in a problem-solving mode down to the pattern-recognition space; and from pattern recognition into the rules-based mode. This is the mechanism by which less-trained people are enabled to do more sophisticated things. This is always the way disruption happens. It enables a larger population of less-experienced people to do more sophisticated things.

When there are unpredictable interdependencies, the integrated player is going to win… If I know what to spec, and I can measure it, and there are no unpredictable interdependencies between what you do and what I must do in response, then an economist would say that is sufficient information for a market to emerge between you and me.

Capitalism has taught us that markets are always more efficient than hierarchical managerial coordination. But… in the absence of sufficient information… management has to provide the coordinating mechanism between what the supplier provides and what the user needs... Management always beats markets when there is not sufficient information.

Too much and too long, we seem to have surrendered community excellence and community values in the mere accumulation of material things. Our gross national product, now, is over eight hundred billion dollars a year, but that GNP - if we should judge America by that - counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who break them. It counts the destruction of our redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and the cost of a nuclear warhead, and armored cars for police who fight riots in our streets. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.

Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity or our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. It can tell us everything about America except why we are proud that we are Americans.

There are essentially two economic models for a company today. The first is a conventional consumerist approach, offering goods and services with no engagement other than producing and marketing. This consumerist model has encouraged a passive relationship with consumers; people expect products and services to be delivered, purely in exchange for money, with no effort or engagement on the individual’s part.

But the most attractive products and services require active engagement. I call the second model the “participation economy” in my book — it’s an economy based on people engaging, seeking influence, and taking part far more assertively in their consumption. Companies need to provide platforms that support this — by letting people more actively participate in the outcomes that they’re looking for, which are a healthy and productive society and reasonably healthy and long lives.

At the heart of the laissez-faire theory is the idea of rational economic actors maximizing their utility by freely choosing among alternatives. From this core premise, theorists posit that all private choices are free of coercion, since the actor is always free to choose another course. In the purest Chicago version of the theory, the only force that interferes with the magnificent, optimizing process is the state; hence state regulation is to be resisted. The state is always coercive; the market, never.

In concluding that only systematic risk matters, finance theory assumes that frictions in capital markets are negligible. The absence of frictions implies that all market participants become as costlessly and equally informed as everyone else — that is, no individual is more informed than others or, to use a technical term, there is no information asymmetry. This assumption, combined with several other assumptions, implies that news events have an instantaneous impact on prices. That is, prices reach a new level immediately upon the news event, thus fully reflecting the news content in price at all times.

Such abstraction from reality helps our understanding of how share prices behave and the role of, and demand for, capital market institutions. This, in turn, contributes to our understanding of the regulatory and standard-setting implications. However, the abstraction comes at a cost. It ignores the extensive role of information intermediaries, the nature of trading, and the transaction costs of trading shares. Recent research has discovered much about the importance of frictions.

This lack of direct disagreement between advocates and critics of NAFTA reflects standard economic theory, which predicts both "gains from trade," meaning higher total income and more efficient production, and "trade adjustments," including job losses and salary cuts for some. "Trade adjustments" sounds pleasantly minor and temporary, but though economists do not like to say so out loud, their texts explicitly confirm that losses can be large and permanent.

Economics leaves the debate at this impasse--a prediction of "gains" from overall growth but "adjustments" potentially harming large groups--because its most basic premises have to do only with gross income. In economic equations a dollar is a dollar, as long as it is adjusted for inflation, whether it accrues to a homeless person or a millionaire. The discipline has no means of comparing one person's additional "utility" from a dollar with another's. It can only be sure that more national income yields greater utility. Economists prefer a higher national income because, in principle, governments can redistribute it to achieve equity and leave everyone better off. Many economists advocate such redistribution, but they are the first to admit that this is a "normative" judgment quite separate from the discipline of economics itself. If NAFTA raises national income (as advocates promise) but distributes it in an inequitable fashion that governments will not remedy (as opponents believe), then the treaty poses a trade-off that economics, by its own assumptions, cannot address.

Whether or not they have ever studied economics, many people seem at least implicitly committed to the idea of homo economicus, or economic man—the notion that each of us thinks and chooses unfailingly well, and thus fits within the textbook picture of human beings offered by economists.

If you look at economics textbooks, you will learn that homo economicus can think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi. Really. But the folks that we know are not like that. Real people have trouble with long division if they don’t have a calculator, sometimes forget their spouse’s birthday, and have a hangover on New Year’s Day. They are not homo economicus; they are homo sapiens.

There is a stream of research -- which economists routinely ignore, reject, or are unable to process -- that shows self-interest is not hardwired but is in fact a social norm that gets stronger or weaker depending on the assumptions that people hold about their own behavior and those around them.

To me, the essence of development is changing the quality of life of the bottom half of the population. And that quality is not to be defined just by the size of the consumption basket. It must also include the enabling environment that lets individuals explore their own creative potential. This is more important than any mere measure of income or consumption.

We have to remember in thinking about all of these things that the financial markets, for the most part, lend long and borrow short. So there are always going to be periods, unavoidably, in which expectations change for one of a million different reasons and you find people in a position where it’s hard to renew short-term loans to finance long-term debt. But we can reduce those problems by improving the incentives of the people who work in those markets.

While a number of socialist critics, most notably Karl Marx, influentially made a case for censuring and ultimately supplanting capitalism, the huge limitations of relying entirely on the market economy and the profit motive were also clear enough even to Adam Smith. Indeed, early advocates of the use of markets, including Smith, did not take the pure market mechanism to be a freestanding performer of excellence, nor did they take the profit motive to be all that is needed.

Even though people seek trade because of self-interest...nevertheless an economy can operate effectively only on the basis of trust among different parties.

[Adam] Smith rejects interventions that exclude the market—but not interventions that include the market while aiming to do those important things that the market may leave undone.

Smith viewed markets and capital as doing good work within their own sphere, but first, they required support from other institutions—including public services such as schools—and values other than pure profit seeking, and second, they needed restraint and correction by still other institutions—e.g., well-devised financial regulations and state assistance to the poor—for preventing instability, inequity, and injustice.

Historically, capitalism did not emerge until new systems of law and economic practice protected property rights and made an economy based on ownership workable. Commercial exchange could not effectively take place until business morality made contractual behavior sustainable and inexpensive—not requiring constant suing of defaulting contractors, for example. Investment in productive businesses could not flourish until the higher rewards from corruption had been moderated. Profit-oriented capitalism has always drawn on support from other institutional values.

The most immediate failure of the market mechanism lies in the things that the market leaves undone. Smith's economic analysis went well beyond leaving everything to the invisible hand of the market mechanism. He was not only a defender of the role of the state in providing public services, such as education, and in poverty relief, he was also deeply concerned about the inequality and poverty that might survive in an otherwise successful market economy.

You cannot legislate the poor into freedom by legislating the wealthy out of freedom. What one person receives without working for, another person must work for without receiving. The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friend, is about the end of any nation. You cannot multiply wealth by dividing it.

The problem is that globalization is being created by business firms, not governments. Business firms are so small that they put one brick in the wall at a time, and don't think about where the wall is going.

So what can we learn from all this? In the words of the great investor Jeremy Grantham, who saw this collapse coming and has seen just about everything else in his four-decade career: “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.” Of course, to paraphrase Keynes, in the long term, you and I will be dead. Until that time comes, here are three thoughts I hope we all can keep in mind.

First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.