Wednesday, October 21, 2009

The Proper Role of Macroeconomists

Last week Mount Olive College hosted a lecture by an economist from the Federal Reserve District Bank of Charlotte. While he presented several interesting facts, his explanation of why the economy was in a recession was unimpressive. He said that it was as if the economy was riding on a bicycle and it was hit by a car. Since the car has sped away the only thing left to do was attend to the victim. There is no sense leaving that poor guy on the side of the road, because he could die if nothing was done.

Maybe I am reading too much into a single analogy, but I think that this story is very telling about the sort of theory that he is operating under. That is, there is no theory. Where did the car come from? Why did it hit us? Are there other cars? Will they also hit us? Macroeconomists call events such as these “Real Stochastic Shocks.” In other words, these mainstream macroeconomists are saying, “We really have no idea when these shocks will happen or how big they will be. These shocks could be anything: a change in the oil market (think early 1970s), the popping of the bubble, the bursting of the real estate market bubble, etc. It’s rarely the same thing twice and we really can’t prepare for it. It’s just a part of the world we live in. It’s sort of like a car hitting you from out of the blue. One thing is certain, the shock wasn’t caused by anything that The Fed did or any policy that Congress and the President have been following. They have no culpability in the existence of the business cycle and thank goodness that they are there with the tools to save us from ourselves.”

This modern macroeconomic story is a blending of the Real Business Cycle and the New Keynesian theories. Unfortunately, neither one of these theories is that; they are not theories! Theories are explanations of how the pieces fit together. The fundamental question of what caused the business cycle is, “Is the cause either a random or a non-random occurrence?” If there is a pattern that can be detected, then the causes of the business cycle are not random. Economics is about finding the patterns in human society.

Fortunately there is a pattern that business cycles follow, but it is not one that the politicians and Fed bureaucrats would like to acknowledge. The pattern is this: the central bank of the US (The Fed) artificially lowers interest rates below the rate that a free market would produce. Whenever the price of something is below its equilibrium price a shortage is created. Normally, a capital shortage would be the result, but since the Fed has the power to create money out of a black hole of nothingness, it is able to “paper over the shortage.” Thus, individuals are reducing their savings (lower interest rates encourage consumption spending) and there is an increase in investment spending. This phase is the artificial boom. The problem is that there simply aren’t enough resources to go around. There is a crisis that manifests itself as either a credit crunch or a real resource crunch. The recession is a liquidation process that is a painful but necessary process to clear out all of the built up malinvestments that were launched during the artificial boom. (I have made an analogy where I assigned my students a big paper that is due tomorrow morning at 8am. They then get hyped up on caffeine (boom) and crash (bust) the next morning.)

The bottom line is this: the economy was not hit by a car. It was not some random event that just happens to us. It was not some unavoidable occurrence that happens in a free market economy. No, the blame is to be placed squarely on the shoulders of the central bank and the rest of the Federal Government. They created the bubble. They say that Wall Street was drunk with greed. Fine, but it was the Fed that was supplying the alcohol. Greed is checked by fear—the fear that you’ll lose your shirt. With the bailouts, that fear has dissipated and it will be worse next time.

The culpability of the Fed also means that their “doing more of the same but larger” measures are not only not going to help the economy, but it is making a bad situation worse. The government is claiming that there is a lack of Aggregate Demand in the economy; that there is not enough spending, but we are spending ourselves into a huge hole. The national debt is nearly $12 trillion. The whole US GDP is only $14 trillion! The average credit card debt is around $10,000. How much more deficit spending can we handle? All of this debt is being supported by a massive increase in newly created dollars. The high wire act that the Fed is claiming to be able to pull off is that as the economy improves, they will be able to pull that money back into the big black pit of nothingness before we see prices skyrocket.

The good economist walks a tough road during a recession. He is blamed for the problem and when asked for advice, the good economist basically tells the policy setters to stop what they are doing and don’t do it again. It is a policy of non-interference, and it is a terrible policy for a central bank and government to take, however it is better than its alternatives. It should be remembered that the hardship endured under a non-interference policy does not stem from the policy itself, but from the fact that the economy is in a recession caused by prior economic interventions. When malinvestments are built up during previous expansionary monetary policies, recessions are the necessary consequence. Going to the dentist due to a cavity is not a pleasant experience, but it is a necessary one for the overall health of the individual. Recessions are terrible economic events, but are necessary for the overall health of the economy.

The best means to transform malinvestments into viable economic activities is by increasing savings. This means that one of the government’s most effective policies is to cut taxes on savers. Those who are savers are usually labeled as “the rich.” Unfortunately, the prescriptions of “get government out of the market” or a “tax cut for the rich” tend not to be politically popular. Regardless, it is the duty of the economist to present the truth. The economist cannot state that the government should do nothing. Such a policy was tested in the early 1930s and failed. The modern economist needs to present the case that the government caused the recession and only by removing the government from the equation can the economy truly recover.


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