Dear Mr. President

Our new president should not forget that unrestrained markets are remarkably successful at delivering many of our most-needed goods and services. But he must also understand the logic of externalities and why in markets like credit—where externalities are significant—a well-planned activist role for government could be vitally important.

Edmund Phelps was awarded the Nobel Prize in 2006 for his work on the tradeoffs between economic objectives. He currently directs the Center on Capitalism and Society at Columbia University.
There are good booms. For example, the Internet boom of the late '90s was a happy time and left lasting benefits. The latest housing boom was different. It buoyed employment, but it proved to be a massive malinvestment that left near-insolvent banks, a credit crunch and an emerging business slump. The debacle has revealed serious flaws in the banking and finance system, which the next president will have to confront head-on.

The absence of owner control over management in the big banks was costly. Bank heads were locked in a competition in which each one "reached for return" as needed to keep profits and share price on a par with rivals—no matter what the risk. Nowhere was there a way for shareowners to say "stop." To prevent that from happening, stronger corporate governance is needed. I would advise the next president to press Congress to legislate that the proposed base pay of CEOs be submitted to a shareholder vote and that bonuses be geared to long-term performance.

The lack of vision in bank management was another flaw. Bankers seemed unwilling to acknowledge and allow for the possibility that interest rates might rise back to more familiar levels and that housing prices (in real terms) were about 40 percent over historical norms. That unwillingness helped create the subprime crisis that's consumed much of the industry. True, the next president cannot legislate "strategic vision." But financial players, instead of communicating and analyzing in terms of a single future, could be required to work with two or three future hypotheticals that include best- and worst-case scenarios.

Finally, the great investment banks ceased to be an instrument of capitalism for the finance of business investment and innovation, and became agencies for "wealth management." It was economic policy that drew banks to mortgages, of course. The American dream became "home ownership" rather than a successful career. To redress the balance, the next president should press Congress to provide businesses with additional subsidies to help them invest, comparable to the subsidies it provides households—through Fanny Mae and Freddie Mac—to buy homes.

If America is to continue to be the place where ordinary people find stimulation, challenge, novelty and fulfillment, our business sector will need more dynamism and inclusion than it has shown lately. This will require a restructuring of the financial sector to serve business innovation. The tiny band of "angel investors" and venture capitalists can't do it all. Also, the next administration must act to stimulate jobs for the disadvantaged, many of whom are now in prison. I have long advocated that a subsidy be paid to each firm employing low-wage workers as a way of raising their pay and stimulating their employment. Barack Obama's planned hiring subsidy is a step in that direction. But we have miles to go to get back on the track for dynamism and inclusion.