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Monday, September 23, 2019

Depression Economics, Part 2

Should government intervene in an economic crisis? Yes. Do we dare to take the risk to let it intervene? No. So what do we do?


In part 1 I explained that the most difficult question in economics is the one about what role government can, and should, play beyond its minimal-state functions. This role is confined to economic depressions - not even recessions. Should government play this role?

This question is difficult for three reasons:

1. Economic theory and experience both suggest that under exceptional, rarely occurring circumstances, there is a role for government to play beyond the minimal state.
2. Economic theory and experience also suggest that even minor misuse of that role will have negative consequences for the economy; the bigger the misuse, the more government cancels the positive effects of its initial activity.
3. There are strong ideological preferences on both sides of this issue trying to, respectively, prevent and hi-jack the exceptional government activity.

The tensions between the economically necessary, the economically destructive and the politically desirable puts the economist in a particularly difficult position. He has to recommend what solid analysis says is the right thing to do and recommend against what the same analysis says will do harm. This is doable; all the economist has to do is be the econometrician he was trained to be, crank out some modeled results and speak in favor of what his numbers suggest. 

What the econometrician cannot do - because he lacks the training - is to take into consideration the ideological component of the question. Yet that dimension is every bit as important in analysis of economic policy as the quantitative reasoning to analyze the costs and benefits of government intervention. 

In fact, econometric analysis is often wrong, especially when it comes to deep economic recessions. Not only do econometricians habitually fail to predict economic crises, but they also fail to assess the long-term effects of economic policy. This is understandable: it is simply not possible to predict economic activity over the long term. There are too many moving parts, the biggest one of which is the human psyche. 

We can generalize how humans behave under different economic conditions, and we can understand fairly well how they respond to economic incentives. But that is all we can do: generalize. The longer our time horizon becomes, the weaker will our generalizations be.

In the first part I explained the role that swings in the human psyche play in guiding the economy through a business cycle. I pointed to how high "as good as it gets" point defines the peak of a business cycle while a low "as bad as it gets" counterpoint determines the trough of a recession.

I also mentioned how, under exceptional circumstances, the bottom can fall out on a recession. When that happens, the absolute majority of economic decision-makers are overwhelmed by enough uncertainty to make them postpone the commitment of scarce resources. Bluntly, in Paul Davidson's classic words: "In times of uncertainty, he who hesitates is saved to make a decision another day".  

At this point, the only remedy for the economy is government intervention. There is no doubts in terms of theory and economic experience that in a depression - not a recession but a depression - the right kind of intervention will replace uncertainty with enough of a predictable economic environment to motivate the private sector to start committing resources again. 

It is of paramount importance to explain immediately that this sort of intervention is not what we have grown accustomed to seeing government do. It is not a matter of massively increasing spending, but of removing obstacles to the formation of confident expectations of future profits. Deregulations and tax cuts may be all it takes, but one should absolutely not rule out that one-time infrastructure investment projects could be part of raising an economy from a depression. 

This is by no means an easy point to make. While there is good economic analysis to suggest that government should indeed play this role under exceptional circumstances, there is equally good economic analysis explaining what happens when government expands beyond this role. Any creation of permanent spending programs as a supposed remedy for a deep economic crisis will permanently change the structure of the economy. 

If it is just one program, it may not change that structure my much, but it still does. A new spending program means a new tax, and often new regulations to go with the program. Any such permanent incursion of government into the economy will erode economic freedom and thereby slowly but inevitably weaken the forces of prosperity. What is gained short term is lost in droves over the long term.

In other words, there is a fine but crucial line between one-time remedies for exceptional economic conditions and permanent alterations to the economy. In theory it is easy to walk that line; in practice it is not. 

This is where traditional economic analysis falls flat. That fall includes econometricians, whose understanding of the economy is limited to what you can fit inside a linear regression; modern Keynesian economists who are theologically convinced of the blessings of government; and Austrian economists whose ability to understand the business cycle is limited by a deeply rooted hatred for government.

The only aforementioned group we should dismiss are the econometricians. Although it is easy to be summarical in a quip about Keynesians and Austrians, both theoretical traditions help us understand the problem of government intervention in a depression. The positive effects of the right kind of intervention are explained in great detail in early Keynesian literature, but it is very interesting to note that nowhere in Keynes's General Theory, or anywhere else in his writings, does he advocate a modern government that actively and permanently redistributes income and consumption between private citizens. 

To ascribe the welfare state to Keynes is an unforgivable afterthought, produced by socialists whose ideological preference overshadowed their economic judgment. 

While Keynes's arguments for one-time government intervention are solid and convincing, Austrian theory explains, with equal eloquence, what happens when we misallocate resources by means of government. Therefore, the only way that government reasonably can fight a depression is if it minimizes the effects of its intervention on the long-term allocation of productive resources.

The only way to do this is, again, to roll out, sequentially, tax reforms, regulatory reforms and one-time projects, for example in infrastructure.

But should we do this? Should government intervene in an economic crisis?

Here is where the ideological tension between socialism and libertarianism comes into play. Libertarians would argue against any government spending projects on the grounds that they breach the confinements of the minimal state. Socialists, on the other hand, would see such projects as a first step into making permanent all kinds of spending programs beyond the minimal state. They would see those programs as a pretext for permanently growing government.

Experience tells us that the socialists win at almost every turn. In fact, their success in growing government has been so overwhelming that it is increasingly difficult to find libertarians even willing to fight the welfare state. This is one reason why it is difficult to recommend any government spending beyond the minimal state at any time

Another reason is that Austrian economists are unwilling to properly understand depressions. This precludes them from helping solve the enormous problems a country faces while in the hole. 

A third reason, related to the second, is the deplorable state of modern Keynesian economics. Keynes's legacy has been infested with socialists, whose ideological ambitions have completely distorted one of the strongest, most solid economic theories of all time. The most insane iteration is Mad Monetary Theory, which is now being pushed by logic-impaired economists and politicians on the left.

Since neither Austrians nor Keynesians are willing to constructively sort through the weed that has grown in economics for so long, it is difficult to see how we could formulate an economic theory of depressions. Given the ideological charge in modern Austrian and Keynesian thought, it is practically impossible to find common ground capable of breaking free from socialist and libertarian ideological shackles.

It is not the case that the long-term suffering of a little bit too much government is worse than the short-term suffering during a depression. That is a meaningless trade-off, simply because we never have the scorecard from the future at hand. However, the risk that any anti-depression policies get hi-jacked is so overwhelming that any policies for the remedy of a depression must be designed and carried out with extreme caution. 

Can it be done? Perhaps. But that is a question for us to return to once we have dismantled the welfare state that has placed an ideological straitjacket on our economy. When that is gone, we can return to the conversation about how to deal with the rare situations when the economy plunges into a depression.

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