The Economic Role of Government

As I tell my students, it is a legitimate and defensible position to argue that the government should not try to manage the macroeconomy. For a variety of reasons (such as corruption, incompetence, and the influence of special interests), it is conceivable that policy makers and implementers will make things worse, not better. If one chooses this position, however, then one cannot complain about high unemployment, high inflation, or a lack of economic growth.

Prior to the Great Depression, the predominant school of economic thought, classical economics, suggested that macroeconomic problems would correct themselves. If unemployment increased, the response would be a decrease in wages until employers were willing to hire them again. Similarly, inflation (a general increase in the level of prices) would cause people to buy less (as prices rose). Reduced demand for products then would cause prices to fall. The biggest problem with classical economic thought, however, is that it is based on assumptions that are rarely true. (For example, it assumes people have full information, which is almost never the case.) Several decades of subsequent economic thought have been devoted to explanations of flaws in the simplistic classical rationale. (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 42 times to 67 Laureates between 1969 and 2010 to highlight and honor those achievements.)

John Maynard Keynes, a British economist, popularized the notion that the government can and should play an active role in managing the macroeconomy. Keynes acknowledged that classical thought might have applicability over an extremely long time period, but “in the long run we are all dead.” If people wait for the macroeconomy to correct itself, they may not live long enough to see the changes. The severity and prolonged duration of the Great Depression convinced most people of the validity of Keynes’ insights. During the Great Depression, prices were falling, but that did not motivate an increase in purchases and employment as classical economics predicts. Even if people had income, they were reluctant to spend it because of uncertainty about the future.

Mainstream economics since the Great Depression is Keynesian economics. The overwhelming majority of economists around the world believe it is appropriate for the government to take actions to promote economic growth and to maintain low unemployment and low inflation. The debate in the United States is not whether the government should try to achieve these goals. Instead, the discussion is about what the government should do. Essentially, Republicans argue that public policies should primarily benefit businesses and the wealthy because they are the job creators. Democrats respond that making the wealthy richer will not cause them to hire more workers unless there is a significant increase in the demand for goods and services. Democrats favor policies with broader benefits because they believe increasing the overall demand for products will increase employment. Very few people argue that the government should do nothing to reduce unemployment, maintain stable prices, and promote economic growth. Indeed, the mood of the country is “they have not fixed the economy, so throw the bums out.”

If President Obama loses the 2012 election, it will be because he did too little to improve the economy, not because he did too much. Reports from the Congressional Budget Office (CBO), a government agency whose professional economists provide non-partisan analysis to legislators, consistently confirm that the American Recovery and Reinvestment Act (ARRA), the much criticized stimulus spending program, created jobs, increased employment, and reduced the unemployment rate from what would have occurred in its absence. It is a fair criticism to say some politicians steered ARRA funds away from the most economically beneficial projects toward other favored objectives. But that is a failure of the political system and the implementation of the suggested policies, not of Keynesian economic theory.

Why are we so willing to repeat history's mistakes?

In the August 20, 2010 Salon editorial "
Why are we so willing to repeat history's mistakes?," David Sirota suggests that the pursuit of money and devotion to ideology cause people to overlook important lessons from history:

Out of all the famous quotations, few better describe this eerily familiar time than those attributed to George Santayana and Yogi Berra. The former, a philosopher, warned that "those who cannot remember the past are condemned to repeat it." The latter, a baseball player, stumbled into prophecy by declaring, "It's déjà vu all over again."

As movies give us bad remakes of already bad productions (hello, "Predators"), television resuscitates ancient clowns (howdy, Dee Snider) and music revives pure schlock (I'm looking at you, Devo), we are now surrounded by the obvious mistakes of yesteryear. And it might be funny -- it might be downright hilarious -- if only this cycle didn't infect the deadly serious stuff.

Vietnam showed us the perils of occupation, then the Iraq war showed us the same thing -- and yet now, we are somehow doing it all over again in Afghanistan. The Great Depression underscored the downsides of laissez-faire economics, the Great Recession highlighted the same danger -- and yet the new financial "reform" bill leaves that laissez-faire attitude largely intact. Ronald Reagan proved the failure of trickle-down tax cuts to spread prosperity before George W. Bush proved the same thing -- and yet now, in a recession, Congress is considering more tax cuts all over again.

These are but a few examples of mistakes being repeated ad infinitum. In a Yogi Berra country, the jarring lessons of history are remembered as mere flickers of déjà vu -- if they are remembered at all. Most often, we forget completely, seeing in George Santayana's refrain not a dark warning, but a cheery celebration. And the logical question is: Why? Why have we become so dismissive of history's lessons and therefore so willing to repeat history's mistakes?

Some of it is the modern information miasma. Though the Internet makes eons of history instantly available, the 24-7, moment-to-moment typhoon of cable screamfests, blogs, tweets, e-mail alerts and "breaking news" graphics makes last week's news feel old, and last month's news feel positively paleolithic. Add to this reportage that is increasingly presented with zero context, and it's clear that journalism is sowing mass senility.

Politicians also make significant contributions to the problem. With the age of the permanent campaign intensifying and the era of the long-term electoral majority ending, both parties deliberately focus only on the very recent past -- and obscure the larger historical record. From the national debt to poverty to the downsides of American empire, Republicans tell us it's all the fault of Democrats' two-year-old reign, while Democrats blame it on Bush's eight-year presidency. This, even though these emergencies developed over decades.

And then, of course, there is ideology.

With the present so radically departing from our past, history has become a damning package of inconvenient truths -- and those truths are often shunned because they threaten today's most powerful ideological interests.

This is why in the debates over war, economics and taxes, we aren't urged to consider past conflicts; we aren't encouraged to remember that America experienced its most storied growth under the New Deal's aggressive financial regulation; and we aren't told that wages and job growth expanded in the mid-20th century with a top income tax bracket above 70 percent. We aren't reminded of these facts because they threaten the defense industry, Wall Street and high-income taxpayers, respectively -- and those forces exert enormous influence over our political discourse, whether through media sponsorship, political campaign contributions or lobbying.

No matter the issue, this axiom is the same: When money has a vested interest in burying history, history is inevitably buried, ultimately leading us from Santayana and Berra's aphorisms to Albert Einstein's definition of insanity: doing the same things over and over again and somehow expecting different results.

Thinking about Being an Entrepreneur? Economic Downturns Can Be a Good Time to Start a Business

According to a June 11, 2009 article in Real Clear Politics by Brandon Ott, now might be a good time to start your own company:

In the middle of a long and bruising recession, perhaps the worst since the Great Depression, starting a new business might not be a bad idea. As counterintuitive as it might seem, successful entrepreneurship in an economic downturn has produced some of the world's most famous companies-IBM, General Motors, Microsoft and FedEx, to name a few. Will this recession prove to be another launching pad from which highly renowned and innovative companies emerge? One can only speculate, but given new research, we might see the top companies of 2020 or 2030 begun in the recession of 2007-2009.

According to a new study by the Ewing Marion Kauffman Foundation, more than half of the companies on the 2009 Fortune 500 list and just under half of Inc. magazine's list of America's fastest-growing companies began during a recession or a bear market.

"You can see the story of the American economy in these numbers," said Carl Schramm, president and CEO of the Kauffman Foundation. "History has demonstrated this time and again: new firms create new jobs and fuel our economy. Policies that support entrepreneurship support recovery."

Recessions are a time of both death and renewal--the so-called "creative destruction" of Joseph Schumpeter. Though we might expect downturns to negatively affect entrepreneurial activity through a lack of available financing and the overall dampening of "animal spirits," there are also reasons to expect recessions and bear markets to be auspicious periods for new business formation.

Rising unemployment can create a pool of highly-skilled, highly-trained workers ready to enter a new field either by starting their own business or becoming employees of a start-up. Financing constraints, common in a downturn, may not impede a firm's birth, but may hinder its growth in the future. Contractions are also likely to weaken competitors, thus making entry easier into a market for a new company.

That's good news for the economy. According to the Kauffman study, job creation of start-up companies is less volatile and sensitive to bad economic times than established companies, which are unlikely to add many jobs despite the economic environment. For example, absent new businesses, the economy as a whole would have added jobs in only one year during the 1990s. Employment created by nascent enterprise, therefore, is vital in sustaining an economy's strength.

Similarly, new business creation seems little affected by recessions and bear markets. In fact, the study says that entrepreneurs' motivation in starting a new company can be a way "to beat unemployment" by taking "the future into their own hands."

Even in this bear market, there are likely to be 400,000 to 700,000 startups in both 2008 and 2009. Since 2001, the average
size of a new firm is 4 employees. When combined, these numbers provide a positive impact on employment that otherwise would be lacking.

In addition to job creation, new businesses also help the economy in a variety of ways. They account for the commercialization of new innovation, often are more productive and flexible than their older peers and have positive effects on already established companies and industries.

As the Kauffman analysis concludes, it is promising to see that even in a depressed economic situation, entrepreneurs are starting businesses and not relying on others to provide for them.

Should the government do anything to prevent economic declines?

Economic declines eventually end without government intervention, but it may take an unacceptably long period of time. The British economist John Maynard Keynes popularized the idea that the government should play an active role in managing the economy. Keynes admitted that an unassisted economy may correct itself in the long run, but “in the long run we are all dead.” We may not live long enough to see the improvement in the economy.

Recessions are caused by insufficient overall spending on newly produced goods and services. Increases in unemployment reduce national income, which in turn reduces aggregate demand further. This deepens the economic decline and may lead to a depression. The length and severity of the Great Depression led most economists and public policy analysts to conclude that it is appropriate for the government to intervene in the economy to try to reduce the severity of recessions and prevent depressions.

See also "Recessions & Depressions: Questions & Answers."

Protectionism was a Result of the Great Depression, Not a Cause of It

In the 17 March 2009 voxeu.org paper "The protectionist temptation: Lessons from the Great Depression for today," Barry Eichengreen and Douglas Irwin argue that protectionism was a result of the Great Depression, not a cause of it.

What do we know about the spread of protectionism during the Great Depression and what are the implications for today’s crisis? This column says the lesson is that countries should coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could once again be most unfortunate.

The Great Depression of the 1930s was marked by a severe outbreak of protectionism. Many fear that, unless policymakers are on guard, protectionist pressures could once again spin out of control. What do we know about the spread of protectionism then, and what are the implications for today?

While many aspects of the Great Depression continue to be debated, there is all-but-universal agreement that the adoption of restrictive trade policies was destructive and counterproductive and that similarly succumbing to protectionism in our current slump should be avoided at all cost. Lacking other instruments with which to support economic activity, governments erected tariff and nontariff barriers to trade in a desperate effort to direct spending to merchandise produced at home rather than abroad. But with other governments responding in kind, the distribution of demand across countries remained unchanged at the end of this round of global tariff hikes. The main effect was to destroy trade which, despite the economic recovery in most countries after 1933, failed to reach its 1929 peak, as measured by volume, by the end of the decade (Figure 1). The benefits of comparative advantage were lost. Recrimination over beggar-thy-neighbour trade policies made it more difficult to agree on other measures to halt the slump.

Figure 1. World trade and production, 1926-1938


The impression one gleans from both contemporary and modern accounts is that trade policy was thrown into complete chaos, with every country scrambling to impose higher barriers. But, in fact, this was not exactly the case (Eichengreen and Irwin, forthcoming). Although recourse to trade restrictions was widespread, there was considerable variation in how far countries moved in this direction. Figure 2 illustrates this for tariffs. Tariff rates rose sharply in some countries but not others. The history of the 1930s would have been very different had other countries responded in the manner of, say, Denmark, Sweden and Japan. It is important to understand why they did not.

Figure 2. Average tariff on imports, 1928-1938, percentage


The answer, in a nutshell, is the exchange rate regime and the policies associated with it. Countries that remained on the gold standard, keeping their currencies fixed against gold, were more inclined to impose trade restrictions. With other countries devaluing and gaining competitiveness at their expense, they adopted restrictive policies to strengthen the balance of payments and fend off gold losses. Lacking other instruments with which to address the deepening slump, they used tariffs and similar measures to shift demand toward domestic production and thereby stem the rise in unemployment.

In contrast, countries abandoning the gold standard and allowing their currencies to depreciate saw their balances of payments strengthen. They gained gold rather than losing it. As importantly, they now had other instruments with which to address the unemployment problem. Cutting the currency loose from gold freed up monetary policy. Without a gold parity to defend, interest rates could be cut, and central banks No longer bound by the gold standard rules could act as lenders of last resort. They now possessed other tools with which to ameliorate the Depression. These worked, as shown in Figure 3. As a result, governments were not forced to resort to trade protection.

Figure 3. Change in industrial production, by country group


This relationship is quite general, as we show in Figure 4. It also carries over to non-tariff barriers to trade such as exchange controls and import quotas.

Figure 4. Exchange rate depreciation and the change in import tariffs, 1929-1935


This finding has important implications for policy makers responding to the Great Recession of 2009. The message for today would appear to be “to avoid protectionism, stimulate.” But how? In the 1930s, stimulus meant monetary stimulus. The case for fiscal stimulus was neither well understood nor generally accepted. Monetary stimulus benefited the initiating country but had a negative impact on its trading partners, as shown by Eichengreen and Sachs (1985). The positive impact on its neighbours of the faster growth induced by the shift to “cheap money” was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion.

Today the problem is different because the policy instruments are different. In addition to monetary stimulus, countries are applying fiscal stimulus to counter the Great Recession. Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion.

The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to “Buy America” provisions and their foreign equivalents. The protectionist danger is still there, in other words but, insofar as the policy response to this slump is fiscal rather than just monetary, it is the active country, not the passive one, that is subject to the temptation.

But if the details of the problem are different, the solution is the same. Now, as in the 1930s, countries need to coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could again be most unfortunate.

References

Barry Eichengreen and Douglas A. Irwin (2009), “The Great Depression and the Protectionist Temptation: Who Succumbed and Why?” (forthcoming).

Barry Eichengreen and Jeffrey Sachs (1985), “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 45, 925-946.