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The Bad Economics of Short-Run Policies

October 3, 2018

Bad economics can bring about or grow out of bad politics. But the question is, what are bad economics and bad politics?

Bad economics can bring about or grow out of bad politics. But the question is, what are bad economics and bad politics? Unless this is clearly and correctly identified, a bad situation can be made worse, and a good situation can be turned into a bad one. So sorting this out is crucial to having a free and prosperous society.

British economist, Robert Skidelsky, is confident that he knows the answer. In a recent article on “Good Politics, Bad Economics,” he states that bad economics and bad politics are free markets and limited government along classical liberal lines. How does he know that such economics and politics are “bad” in their effects on the society? The financial crisis of 2008-2009, Skidelsky says, was due to unbridled financial markets combined with “hands-off” economic policies once the downturn set in, in 2009-2010.

Good politics and good economics, in his view, comprise an openness and sensitivity to the concerns of many in the society for social securities and job assurances in a changing and uncertain world. Oh, Adam Smith’s invisible hand of unhampered free markets is fine enough when taking the long view, but, Skidelsky says, they are “also highly disruptive and prone to periodic breakdown,” in the shorter run.

Skidelsky: Populist Demagogues as Good Economists

Adhering to such Smithian free market policies opens the door to “populist” demagogues, such as Victor Orban in Hungary who has instituted illiberal political policies attempting to restrict civil liberties and personal freedom. But, on the other hand, as far as Skidelsky is concerned Orban has a highly redeemable set of good fiscal policies, based on a “sound Keynesian footing.”

This echoes back to the infamous forward that John Maynard Keynes (1883-1946) wrote for the German translation of his, The General Theory of Employment, Interest, and Money (1936), that “The theory of output as a whole, which is what the following book purports to provide, is much more easily adapted to the conditions in a totalitarian state than . . . under conditions of free competition and a large measure of laissez-faire . . .”

It is worth recalling that in 1936, the only remaining academic economists to whom the content of Keynes’s book could be addressed in recommending it as a guide for government economic policy were Nazi economists, since all others already had been removed from university and related positions by Hitler’s National Socialist regime.

Following in the footsteps of his intellectual mentor (being the author of a highly regarded three-volume biography of Keynes), Skidelsky points out that illiberal nationalist regimes such as Orban’s find it far easier “to pursue policies of social protection.” Why? They can use the heavy hand of government control to impose such policies on society without the type of resistance or public criticism possible in a more politically open liberal system.

The Bigger the Government, the Better for Keynesians

The smaller the government’s fiscal presence in the economic activities within a country, the less is likely to be the impact from “activist” government spending policies, since government expenditures and taxation would be relatively small to start with. If there is, say, a $1 trillion economy, with government taxing and spending only representing one percent (or $10 billion), a 20 percent increase in government spending in the form of a budget deficit only comes to an additional $2 billion.

But if, on the other hand, out of a $1 trillion economy, government taxing and spending comes to, say, 20 percent that is equal to $200 billion. If, now, the government increases it’s spending by only 5 percent through deficit financing that comes to $10 billion, or five times as much as in the first case.

Keynes’s point, and Skidelsky’s, is that the greater the degree of government influence or control over the economic activities within a country to begin with, including the size of government spending as a percent of the economy as a whole, the larger the impact from any increase in spending by that government. The bigger the government, the more policy-relevant is the introduction or expansion of Keynesian-type fiscal policies.

In fairness, Keynes had no sympathy for the ideology or the politics of the Nazi regime in Germany, and Robert Skidelsky is equally unsympathetic with the political and cultural policies of Orban’s government in Hungary. But Skidelsky believes that the best way to prevent or make less likely the coming to power of a populist, “right-wing” government like Orban’s is for a more liberal and democratic government to introduce “good” Keynesian and other interventionist policies before economic circumstances become so bad in a country that the citizens turn to an Orban-type of leader, due to the affects of “bad” free market policies that limit the size and scope of a government to “fix” and set things right.

Bastiat and Hazlitt: Good Economists Look Beyond the Short Run

Slightly modernizing the insight of the French free market economist, Frederic Bastiat (1801-1850) in his famous essay, “What is Seen and What is Not Seen,” economic journalist Henry Hazlitt (1894-1993) explained the crucial difference between a “bad” and  “good” economist in his classic, Economics in One Lesson (1946):

“The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group, the good economist inquires also what the effect of the policy will be on all groups . . .

“The long-run consequences of some economic policies may become evident in a few months. Others may not become evident for several years. Still others may not become evident for decades. But in every case those long-run consequences are contained in the policy as surely as the hen was in the egg., the flower in the seed . . . The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences not merely for one group but for all groups.”

Now no personal or moral slight is intended by implying that Robert Skidelsky, by Bastiat’s and Hazlitt’s definition, is a “bad” economist. It simply means that it is “bad economics” if the analyst, for whatever reason, exclusively or primarily focuses on the immediate or nearer effects from a government policy while ignoring or downplaying the possible or likely impact of such policies when taking the longer-run perspective on what the consequences of a policy may be.

The reason being, as the old adage says, “the road to hell is paved with good intentions.” It is clear from Skidelsky’s argument that he is concerned that if a “good” or well-intentioned government pursues “bad” economic policies, it may create the political conditions in which an authoritarian or populist demagogue may be able to promise “good” interventionist economics, some of which he might even successfully deliver, but at the cost of reduced or lost political and civil liberties.

However, a “good” diagnosis requires a correct judgment concerning the cause and nature of the (social) ailment. Otherwise, the illness may be made worse, or at a minimum recovery may be delayed or prolonged more than otherwise might have been necessary.

Short-Run Policies Created the 2008-2009 Crisis

What Skidelsky interprets as the economic system prevailing in the United States and most other Western countries has little to do with how classical liberals define a “free market.” Financial markets have been and are heavily regulated by government regulatory agencies. The creation of money and credit and the rates of interest they charge to borrowers are not truly market-based. Central banks set the regulatory and loan-creating rules for the member banks within the banking systems.

Governments and their central banks created the financial crisis of 2008-2009. For years the Federal Reserve had been increasing the quantity of loanable funds in the banking system, and when adjusted for price inflation as measured by the consumer price index, some real interest rates were negative. (See my article, “Interest Rates Need to Tell the Truth”.)

In other words, loan money was being handed out for free in terms of real buying power that a borrower was paying back to lenders for the period of their loans. To get the central bank-created money in the banking system out the door, besides the equivalent of negative interest charges on some loans, the banks were induced to extend loans to uncredit-worthy home buyers with the promise that government agencies like Fanny Mae Freddie Mac would pick up the tab if and when the loans went bad – which many eventually did.

Bad Economics and Short-Run Politics Cause Society’s Ills

What had motivated these policies? In the case of the Federal Reserve, a fear in the early years of the 21st century that there might be a tendency for price deflation, which the Fed Board of Governors decided had to be prevented at all costs through counter-acting monetary expansion. The longer run consequence was an unsustainable financial and investment bubble that came crashing down in 2008-2009. (See my article, “Don’t Fear ‘Deflation,’ Unless Caused by Government”.)

In the case of the housing market, pressures by members of Congress were placed on the government’s home loan guaranteed agencies – Fannie Mae and Freddie Mac – that not enough people were attaining the American dream of having their own home, especially among members of minority communities in the United States. So credit standards were lowered or seemingly almost waved. Banks were told not to worry; just extend home loans to those not meeting the traditional credit-worthy standards of income and work history or not enough of a usual down payment, because if things went wrong those government agencies guaranteed to cover any that went “bad.”

Misplaced fears about possible price deflation and the pressures of politicians looking no further than needing votes from happy home-owning constituents; these were the short-run policy contexts that created the longer run disaster of one of the severest economic downturns of the post-World War II period.

Macroeconomic Mindset Prevents Understanding of Markets

Both factors reflected the bad economics of focusing on the short-run. The Keynesian mindset is to have the monetary central planners try to micro-manage every twist and turn in the financial and economic climate, and frequently turn the money-creation and interest rate dials in an attempt to keep the macro-economy on an even keel, as the defined by the Keynesian-oriented policy makers.

The same applies to using government taxing and spending to try to influence investment, employment and wages in the economy as a whole. But, again, what this mindset summarizes away in the macroeconomic aggregates used as indicators and targets are the complex and interconnected microeconomic relationships in the structure of relative prices and wages, relative profitabilities of directing productions to satisfy multitudes of different consumer demands, and the need for on-going and continuous adaptations and adjustments in prices and wages, and the allocation of resources (including labor) for successful economy-wide coordination of what everyone is doing in the social system of the division of labor. (See my article, “Macro Aggregates Hide the Real Market Processes at Work”.)

The Best Short and Long Run Policy: Limited Government

For a market economy to succeed in this endeavor the only long run set of policies for any government needs to undertake is to protect the individual and private property rights of the citizenry, enforce all contracts and agreements peacefully and voluntarily entered into that are not fraudulent or misrepresentations, and prevent foreign aggressors from invading and plundering the people within a country.

This represents the “good politics” of a (classical) liberal political order that helps secure people’s liberty and assures the economic setting most conducive to prosperity and price-guided market coordination. A stable and healthy market order such as this precludes the likelihood of the disruptions and distortions that are central to Skildelsky’s concerns.

If such disruptions do arise for some external reason, it remains nonetheless the best long run and short run policy for open and competitive markets to be left free to rebalance and recoordinate in the most appropriate and timesaving ways possible. Government planners, regulators and bureaucrats can never know or acquire the needed and necessary microeconomic knowledge of time and circumstance that only the actors within the various sectors of the economy can discover and attempt to utilize in the most effective manner.

Following this type of economic policy approach is most likely to preclude the emergence and attractiveness of the populist demagogues that Skidelsky fears as threats to political freedom and civil liberties. His proposed policies are far more likely to bring about the very “bad politics” about which he is rightly concerned.

[Originally Published at the American Institute for Economic Research]

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Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel.