How Not to Fix a Recession

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Mass unemployment and long-term unemployment are tragedies. From all sides we hear the cry for “jobs, jobs, jobs.” Recovery from a business recession does create jobs. More importantly, it restores lost production of the necessities and pleasures of life, for which work is a regrettably necessary means rather than an objective in itself.

Before endorsing artificial creation of specific jobs and other ad hoc “stimulus” measures, we should understand what a recession is — a disruption of economic coordination. Frederic Bastiat, Henry George, and Wilhelm Röpke, among others, wondered in almost poetic language at the spontaneous, market-driven, coordination of local and national economies and of the world economy. Contacts are established among business firms and between firms, workers, and consumers. A pattern of production and prices is established and continuously adapted that takes account remarkably well of resources, technological possibilities, and the wants of people as workers, consumers, employers, and investors. Things hang sensibly together, and with no central planning and direction.

Occasionally, though, this marvelous meshing of mil- lions and billions of individual plans goes awry. A standard example has to do with unemployed workers who would gladly buy more products if only they could earn incomes to pay for them, and of employers who would gladly hire more workers if only they could find customers for their products.

The defect in such a case is not — not fundamentally — insufficient aggregate demand; it is not too little spending to buy the output of a fully employed economy. Fundamentally, supply creates demand: people specialize in producing particular goods and services to trade them away, sooner or later, for the specialized products of other people. These transactions do not take place by barter, however; instead, money and credit must lubricate them. Sometimes these lubricants fail.

Recessions typically result from too-tight monetary policy. Disruptions of credit in particular, rather by exception, have caused our current woes. There is plenty of blame to share, as by financiers who scarcely understood their newfangled issues of securities based on other securities based ultimately on shaky mortgages, as well as insurance issued against default on debts. The financiers were responding, moreover, to faulty incentive structures. These errors, although not excused by a background of misguided government interventions, did occur against that background. Policies of artificially easy money and credit and of promoting homeownership even by financially unqualified buyers fed a speculative housing boom that was bound to collapse. The collapse brought a chain reaction of bankruptcies, loss of confidence, contagious panic, and hesitation to grant credit and spend money.

Ad hoc remedies might do some good in the short run. Exaggerating for dramatic effect rather than making a serious proposal, Keynes even imagined that hiring workers to dig and refill holes in the ground might not be the worst policy. Far better, however, is to facilitate firms’, workers’, and consumers’ groping their way back to market-clearing prices and to restoring or replacing business contacts, as they have often done before. An adequate money supply — certainly not lacking nowadays — would ease this pro- cess of restoring coordination.

Ad hoc and unpredictable interventions, however, are an obstacle to recovery, as in the 1930s. Plagued by uncertainty and even by fear, banks and other lenders hang onto their money, as do business firms and consumers. Potential investors hold back from projects, and potential employers wait to see what happens before restoring their payrolls. Will the Federal Reserve be able to reverse its massive emergency expansion of its balance sheet, possibly at the cost of renewed recession? Or will the activation of idle bank reserves and cash balances cause severe inflation? How will the government deal with its swollen deficit and debts? Will it partially repudiate its bonds and entitlement promises, perhaps openly but more probably by inflation? Will the Chinese and Japanese lose confidence in U.S. bonds, fleeing from the dollar and triggering its collapse? Will new taxes somehow save the budgetary situation, and if so, what sort of taxes? Will the so-called Bush tax cuts be allowed to expire, or will some of them be extended or replaced? Will the tax code keep on getting more complicated and hard to comply with? What sort of healthcare reform will be imposed, and at what cost to employers?

Stimulus programs of the recent sort hardly inspire confidence, with their invitation to pork barrel projects, their misallocation of resources, and their outright destruction of wealth (as by “cash for clunkers”). Switching t o“green” energy, often recommended for creating more jobs than reliance on traditional energy, also means waste; for it would reduce the productivity of labor in energy production.

Imagine: seeking prosperity by destroying wealth! Have politicians forgotten Bastiat’s refutation of the bro- ken-window fallacy? Given politicians’ short-run orientation, capriciousness, and apparent contempt for the very fundamentals of economics, it is no wonder that business- people would rather keep their options open than show the spirit of enterprise.

Concern with the psychological aspects of business cycles – contagious over-optimism, contagious fear, and herd behavior — is becoming more and more respectable among academic economists, even though it lends itself less readily to elegant formalization than what has so far occupied theorists. Bruce Yandle’s “Lost Trust: The Real Cause of the Financial Meltdown” (Independent Review, Winter 2010) and George Akerlof and Robert Shiller’s “Animal Spirits” (Princeton University Press, 2009) are examples of this increased respectability.

“Jobs, jobs, jobs” — or rather, their results in the form of desired goods and services (as well as workers’ pride in productive activity) — are a worthy objective; but ad hoc measures that increase uncertainty, undermine confidence, and perpetuate fear are no way to achieve that objective.

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