There is an argument going on which has real life consequence for all of us. This subject has taken on an urgency because of what is going on in the economy right now, but in reality, it is a fairly old debate. The questions are:
1. What caused the current financial and economic crisis?
2. How does the current crisis compare to the Great Depression?
and most importantly,
3. What should the government do?
There is an infinity of answers, but I am going to categorize them into two broad, somewhat oversimplified camps: the Keynesian interventionists and the Austrian-school libertarians. For the interventionists, I will pick Professor Paul Krugman as the standard bearer. For the libertarian camp, I will pick Congressman Ron Paul. Though both have their political affiliations, neither of them have been close to positions of power, so you cannot accuse either of them of actually causing anything, unlike other partisans to the debate. I am going to state their arguments as clearly as possible, but be aware of my own libertarian bias.
1. What caused the present crisis?
The interventionist crowd argues that it is a failure of the market, which itself was caused by the failure of government to adequately regulate the financial industry. Many years of ideologically driven hands-off Federal Reserve as well as government policy led to a relaxing of regulatory standards and oversight. This led to excessive risk taking, which led to the crisis.
The libertarian crowd argues that it was the Federal Reserve that primarily caused the crisis, with its faulty monetary policy. The Fed's asymmetrical policy led to a series of asset bubbles, and as each bubble burst, monetary policy became ever easier, leading to excessive risk taking with borrowed money. There was an implicit assumption among speculators that the Fed would come to the rescue, so really bad things cannot happen. Overall debt in the economy, expressed as a proportion of GDP, increased to historic levels.
One complication in this is Alan Greenspan, the Chairman of the Fed during the entire time, used to consider himself a libertarian, but people like Ron Paul had been warning him of his reckless monetary policy all the while, so from a libertarian point of view, Greenspan was only libertarian-in-name.
More recently, Greenspan seems to have conceded that more government regulatory oversight may have been needed, placing himself belatedly and partially in the interventionist camp on what caused the crisis.
2. How does the current crisis compare to the Great Depression?
Both camps would agree that the present crisis has disturbing parallels to the Great Depression, but the agreement would stop there. They fundamentally disagree on what prolonged the Great Depression, and finally how the economy got out of it.
Interventionists argue that it was the Fed's deflationary money policy that led to the Great Depression, therefore the foremost responsibility of the Fed today is to keep monetary policy easy, to prevent deflation. Interventionists also argue that it was the New Deal economic policies that by and large pulled the economy out of the depression. In fact, interventionism itself became the dominant school of thought with the New Deal.
The libertarians argue that deflation was an inevitable consequence of a badly distorted economy created by an artificial credit boom, adjusting itself back. In particular, bad investments made during the credit boom had to be written off, asset values had to find their true level, and that was the only way to cure the economy. Left to itself, the economy would have had a short, deep recession, and as price levels adjusted, economic activity would have started to climb back. In the libertarian view, government intervention actually prolonged the depression.
3. What should the government do now?
We already know the answer to this one: we are going to have a series of government interventions, each bolder than the previous one. By far the dominant school of thought today is the Keynesian inverventionist camp. Contrary to partisan political rhetoric, the difference between the two political camps is fairly mild, and deals with really how much intervention is too much.
Libertarians are but a fringe and are mostly considered relics. I happen to belong to that fringe, which is why you even read about them in this blog! As Professor Krugman advises President-elect Obama (emphasis in the original):
Implications for Obama: be inspired by FDR, but don’t imitate him slavishly. In particular, your economic policy should be bolder, not more cautious.
As I said in the beginning, this is going to be of momentous consequence. If the libertarians are right, we are in for really, really tough times, and bold interventions of the kind Krugman advocates are only going to prolong the misery. In any event, we are going to be subject to a real world experiment. Let's wish ourselves luck.
So what would constitute success in this experiment? Let's set some simple goals: a) unemployment should decline in 4 years, so let's say that if unemployment in 2012 is less than 6%, interventionists have succeeded b) inflation should be reasonably contained - let's say under 4%.
Update: I would add a debt covenant, so that US government debt, as a percentage of GDP, should not exceed 100% - it somewhere in the 80% zone now. Japan's various interventions over 18 years have resulted in doubling their public debt - now at 160% of GDP. Japan still hasn't fully recovered from its own bubble burst in 1990, which should give pause to the interventionists.
I would be happy to acknowledge the interventionists' success, of course.
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