^*Michael Mussa has been a senior fellow at the Peterson Institute for International Economics since 2001. He served as Economic Counselor and Director of the Department of Research at the International Monetary Fund from 1991 to 2001, where he was responsible for advising the Management of the Fund and the Fund's Executive Board on broad issues of economic policy and for providing analysis of ongoing developments in the world economy. He served as a Member of the U.S. Council of Economic Advisers from August 1986 to September 1988. He was a member of the faculty of the Graduate School of Business of the University of Chicago (1976–91) and was on the faculty of the Department of Economics at the University of Rochester (1971–76). During this period he also served as a visiting faculty member at the Graduate Center of the City University of New York, the London School of Economics, and the Graduate Institute of International Studies in Geneva, Switzerland. Mussa's main areas of research are international economics, macroeconomics, monetary economics, and municipal finance. He has published widely in these fields in professional journals and research volumes.

Abstract

Financial crises have occurred periodically for hundreds of years, and Adam Smith had important insights into their causes. Although by no means all that we know about such crises has been derived from Smith, it is interesting and important to reflect on what he did know and how ignoring his warnings about the creation of excess liquidity has contributed to the current crisis. In addition to the complexity of contemporary finance and the role of central banks and other regulatory institutions, a major difference between Smith's day and ours is the emergence of "moral hazard" as an important policy issue and its corollary, "immoral results." It is important to realize that the risks of financial crisis, moral hazard, and immoral results cannot be avoided by financial and accounting gimmicks, and that there is no substitute for adequate capital in the creation of liquidity.