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How To Handle The Great Recession, Part I

September 2008 will go down in history as the start of long period of economic disturbances. As of July 2010, we are still right in the middle of the greatest economic crisis since the 1930s. Some people compare our current situation to the summer of 1931, when a worldwide serious of bank closures turned a normal recession into the infamous Great Depression. Both policy makers and economists worldwide seem to be confused right now. Should the government spend more, spend less, or should the central banks print more money?

I wouldn’t say that I know more of this crisis and the economic mechanics behind it than most famous economists. However, I think that many economists don’t have the guts to publicly tell how it is, either out of political reasons or because they don’t want to upset their employers. So, as long as I’m a student and therefore “independent”  I’d like to give you my take on this Great Recession and how to handle it properly.

Let’s start with the causes. Austrian schoolers say it was low interest rates and moral hazard, mainstream economists say it was insufficient regulation (and maybe moral hazard, too). As a matter of fact, economists still don’t know much about business cycles. We still don’t know precisely what caused the Great Depression of the 1930s. I guess we won’t know the exact reason(s) for our current crisis for many more years. The mainstream critique of the Austrian school explanation of the business cycle seems correct to me (they say that investors can’t be fooled forever/repeatedly by low interest rates), though I have to admit (feeling somewhat ashamed) that I haven’t read much from the Austrian school yet.

However, I concur with Austrians when they critizise macroeconomists for their seemingly indefinite trust in their ability to steer the economy. Economists still don’t know much about some very important things like:

– What is the “equilibrium” real interest rate?

– What is the optimal inflation rate in the long run?

So I can’t back up my opinion with really reliable theories when I say that the cause of this crisis was excessive credit expansion through loose monetary policy. Anyway, most economists (me included) think that there should be something done against banks going moral hazard, for that is certainly backed by reliable theory (and human logic). The only two feasible solutions that come to my mind are:

Deregulate (sic) the financial sector, abolish the central banks and return to a Free Banking system, in which no bank will be bailed out. Thereby, banks will invest much more conservatively and hold much more equity instead of debt. The risk is (again, economists don’t really have a theory for this) that the necessary shrinking of banks’ balance sheets (through the reduction of debt relative to equity) could lead us into twenty years of depression. As far as I know, economists don’t know if our economies really need these huge amounts of debt that are generated by fractional reserve banking. So, how much would it hurt to go back to full-reserve banking? No one knows…

– Regulate (sic) the financial sector, force banks to hold at least 20% of their assets as reserves.

Now, let’s turn to short-term policy prescriptions. Governments have acted like true Keynesians for the last two years, pumping “fiscal stimuli” into the economy. Many economists (even before this crisis) found strong evidence that the costs of “fiscal stimuli” like infrastructure projects or other work-related programs are higher than their positive effects. Mainstream economists will agree that Keynes was right when he said that there can be a vicious circle of debt-deflation and lack of investment in economic depressions. However, Keynes was wrong when he thought that government spending can cure this problem. Governments don’t know where to find the most productive investments. That’s not surprising, for politicians are no business men and the government is not a profit-oriented corporation. So how ’bout governments supporting private companies’ investments during depressions by making investments cheaper? That’s called “a tax break”. I think Keynes would support that.

So, we should reduce taxes and reduce government spending. There is empirical evidence that reducing taxes by $1 increases national income by more than $1. At the same time, reducing government spending by $1 should reduce national income by less than $1, according to empirical findings. That way we could have a real stimulus to the economy. And the best thing is: it would also reduce the deficit and the debt burden of the government. Instead, our governments pump billions into the economy that result in net losses to our economy and, at the same time, the amount of debt explodes and brings us ever nearer to the point where the government will have to stop spending and increase taxes, ruining what is left of the economy then.

Meanwhile, monetary policy can help the government by inflating the economy. However, central banks should rethink the way they do this. Pumping trillions into banks seems to have no effect whatsoever on consumer price inflation, ask Japan. Giving money directly to the citizens via checking account may make more sense. Of course, this can only be a temporary measure. The potential for political abuse is so large that it should be done only as a last resort.

To conclude, Keynes, the Austrian school, mainstream economists, they all bring forth some sensible ideas, but most of them (except the Austrians, probably) lack a basic understanding of public economics and the dangers of political abuse of economic policy tools. As Henry Simons once said: “[Keynes] may only succeed in becoming the academic idol of our worst cranks and charlatans – not to mention the possibilities of the book (The General Theory of Unemployment, Interest and Money) as the economic bible of a fascist movement”. HT EconomicPolicyJournal.com

And it’s certainly not only Keynes who’s guilty. Many modern mainstream economists propagate possibilities to make society more equitable by designing tax systems according to utilitarian principles, for instance, make sales tax exemptions for goods that are mostly consumed by low-income people. Experience shows that there can’t be exceptions in policy. The slippery slope really exists. Lobbyists use exceptions in sales taxes or income taxes or import tariffs to get ahead of their competition. Politicians play the game because some of them are on the hunt for votes, some may even receive nice gifts in exchange. The same goes for many other issues, for instance, monetary policy: Once the gold standard was abolished, governments could spend as they like and print money if all goes horribly wrong.

Modern economics has many “interventionist” tools at its disposal, many of them pretty effective. However, as with weapons, it’s sometimes better not to use them at all. Furthermore, there are still many important issues unresolved. Economic theory is so incomplete that economists should take a more humble approach. And society should recognize that there are some tools that should better not be used, and that there are problems that can’t be easily solved because we don’t have theories for them yet.

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