Volcker, the former Fed Chief says the US is in recession. Reactions to the recession forecasts have been strong. Gloom abounds. People are running around panicking like chickens. Conservatives are making gloomy predictions about how this will play out. In a recent article on the economy, David Brooks makes one such attempts at soothsaying. He predicts that Obama will ride this tide to a liberal overreach which will be followed by a conservative backlash. Very plausible.
Meanwhile, another interesting philosophical debate wages between liberals and conservatives, about whose view of the economy is right.
The liberals are crying vociferously that this means the end of free markets and the GOP approach to economics. They say it proves the GOP theories failed.
Meanwhile, the Libertarian fiscal conservatives are shouting that Bush is leading America to socialism, as illustrated this article on Ron Paul's economic adviser railing against Bush's socialism.
In a recent article on CNN, Jeffrey Miron, makes his case for free marketers, and waxes eloquently on why bankruptcy not bailout is the answer. Essentially, he points out that the bailout will reward the worst excesses and thereby facilitate the return of such excesses. By letting banks fail, you ensure that the system self corrects itself to a state where everyone is more prudent. You won't get good behavior, if you bail out the offenders every time they slip up. He also suggests that efforts to intervene will either distort the market or fail completely. On the whole, he advises doing nothing.
Others though are less sanguine. George Soros and others are pointing out that the free market system assumes that markets are self correcting. However, Soros suggests that the evidence is that markets are not. That to be self correcting they need regulations that ensure that the players play by the rules.
Others like Sloan point out that what is happening is just normal market correction and the cries of socialism or calls for re-examination of the whole structure of government are premature and unwarranted.
Meanwhile, Nassim Taleb is challenging one of the fundamental tenets of derivative pricing and thinks their Nobel prize should be revoked. Taleb's explanation is that the formula used by Merton, Black and Scholes was a widely known formula for Markov chains, and they merely applied it to economics. Further, he points out that the data shows that the Black Scholes approach is fundamentally wrong, as it assumes the distribution of rate changes is normally distributed, when in fact, the data shows that there is a significantly higher probability of extreme events than predicted by Black-Scholes.
So, which view is right? From a Scientific perspective, all the theories have merit. For instance, Supply-side and Keynesian economics both work. There is mountains of evidence that both do. There is mountains of evidence that blind adherence to one or the other doesn't. In the Asian crisis in the mid 1990s, Malaysia and Thailand went in opposite directions, and the results for their economies was much the same. So, net net, the economic theories seem a wash.
The reason of course has to do with the fact that these debates fail to realize two essential elements of economic theory. The first is that while economic theory can help frame up the debate about what could happen if you did A vs. B, it says nothing about which is better. What would happen is a scientific question and amenable to testing, whether it is good is a moral question and a choice.
For instance, raising taxes indefinitely would in fact reduce growth. However, not providing services like social security, defense, basic infrastructure, etc. for the economy, could be devastating for many people. So, taxes are necessary, too much is not. There is of course a trade-off. How much is good? The answer is how important is protecting people, providing healthcare etc. vs. making lots of money? By the way, it can be shown that at a certain point, the infrastructure will fail to the point that incremental tax breaks will no longer generate growth, but will retard growth.
The choice therefore is a moral one.
In a pure free market system, the length of the recession can be very long and the interim downward spiral would punish a lot of market participants. The people hardest hit would be those at the fringes, i.e. the poor and the middle class. If things were allowed to play out, ultimately it might correct, but not before wreaking devastation on huge numbers of people. The reason pure free market economics has never been applied in full is that whenever things get bad, the usually powerless populace reacts badly, voting out or throwing out the government and demanding change. The longer free market approaches are tried in bad times, the more political instability it creates.
Supply side economics works too. It enriches richer people first and prioritizing the plight of poor people lower. Ultimately everyone benefits. Given the incentive to rich, means that powerful market participants invest heavily, driving investment and growth. However, in general, while the benefits do trickle down, in most economies that have tried this, income disparities have grown, not shrunk. Ultimately, what that means is that poor people have substantially lower risk tolerance and richer people (i.e. people who drive the economy) have substantially higher. Ultimately, when the people in power can no longer empathise with people who are not, it can lead to very stupid risks - i.e. bubbles.\
Keynesian theories work too. The problem with them is that the allocation of money by the government is almost always a political decision and not an economic decision. Also, governments are notoriously bad at cutting back in good times. The effect of the two is that Keynesian intervention often creates huge market imbalances, lower productivity, higher structural unemployment (usually because giveaways reduce the incentive for people to go and find work), and significantly greater long term inflationary risk - because of government's inability to cut back. On the other hand Keynesian approach substantially reduces the impact on poor and middle class, and minimizes the risk for them.
Properly regulated and governed, in all three you can avoid the worst excesses.
These are no where near complete analysis. However, the larger point is that we need to choose what effect is desirable and choose the best tools to achieve it. No amount of examination of the tools can reveal the ideal goal.
This brings us to the second fallacy. As Soros points out, all human systems are flawed. And every decision has a measure of good and a measure of not so good. The good and the not so good can be concentrated on particular sections of the economy or spread around. Over time, the dogmatic continuation of any philosophy will create sufficient accretion of the not so good aspects where the good of that policy no longer offsets it. At that point, you need a different solution.
This brings me back to David Brooks' article. In the article, David Brooks describes the effect of an Obama government, and predicts that it will ultimately result in the revival of conservatism. It's not very clear whether he wants to pass judgment, but there is just a hint that conservatism in its purest form is the better philosophy. However, in describing the effect, Brooks has explained something else very eloquently - that governments in democracies are also market participants. The swing from liberalism to conservatism in a sense is the attempt by the market to find a balance between the evils of competing approaches. The longer we double down on one or the other philosophy, the more the imbalance it creates, and the more the need for a change in direction. So, what Brooks, describes a market place where the competing ideas seek balance and equilibrium. In this sense, democracy is enabling the free market to help drive the moral choices we make.
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