Toward an Effective Macro Policy Solution

|
 |  Includes: AGG, DIA, SPY
by: James Picerno

Everyone has a prescription for managing the business cycle these days, but no one has a solution. That’s because there are none, at least nothing that passes the smell test of a workable system that can deliver nirvana: maintaining capitalism’s power to drive economic growth while eliminating its tendency for stumbling from time to time.

Bridging these two facets, which are inextricably linked, is at the center of the debate. Obvious solutions, however, are elusive, and probably always will be. The fact that a range of policies have been tried over the decades, and delivered mixed results, is testament to the idea that there's always a cost to every "solution."

No less a critic of unfettered capitalism than Hyman Minsky recognized the limits of pushing too far on one end without biting too deeply into the benefits on the other side. “We need to embark on a program of serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved,” Minsky wrote in Stabilizing an Unstable Economy. "Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so evident in history."

Finding the middle ground won't be easy this time, but it should be tried, argues economist Bob Barbera in last year's The Cost of Capitalism. He wisely notes that "one cannot forget that the essential driver in free market capitalism is the risk-taking entrepreneur, bankrolled by the world of finance. Enlightened societies, therefore, need to embrace free market capitalism, coupled with policies aimed at increasing margins of safety and tempering flights of fancy."

The challenge is figuring out exactly where productive policy prescriptions end and self-defeating market regulation begins. In fact, much of the political and economic debate since the 1930s in the U.S. has been focused on that question, and the results to date are still mixed.

Keynesian intervention of one sort or another is widely embraced as the general framework for finding this sweet spot these days, but past missteps and excesses in applying the principles outlined in The General Theory of Employment, Interest and Money should give one pause for expecting too much. In the 1970s, an active fiscal policy intent on maintaining full employment backfired with stagflation.

Some say the errors in the '70s were less about Keynesian failure vs. an oil price shock and loose monetary policy. In any case, defenders of aggressively managing the business cycle fell out of favor. In the wake of the downfall rose the neo-classical economists led by Milton Friedman. Although Friedman's insights and opinions ranged far and wide, his basic prescription was one of favoring markets and recognizing the power of monetary policy for good or ill. As he and Anna Schwartz argued so persuasively in A Monetary History of the United States, 1867-1960, the central bank's printing presses are a critical and often overlooked factor in the ebb and flow of economic fluctuations.

But there's a case to make that the Fed ignored the lessons of history and kept monetary policy too loose for too long for much of the first decade of the new century. Are we doomed to repeat history? Even when the lessons are clear?

Now the pendulum is swinging back toward a Keynesian view of the world, or perhaps a Keynesian/Minsky interpretation, and not without cause. Certainly there's a case for seeing the banking sector as something unique in the economic sphere. There's a limit to letting free market forces have their way with banks, which is part of the reasoning for central banking. The lender of last resort is a concept that arose out of necessity. Letting banks fail runs the risk of allowing a bank run to terrorize the economy.

At the same time, there's a limit to how much government can do to minimize the risk of financial failure. As Jean-Charles Rochet explains in Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation, "supervision [of banks] and market discipline are more complements than substitutes: one cannot work efficiently without the other."

Government management of economic cycles is arguably necessary to some degree but also dangerous if it goes too far and costs too much. It's too early to say what's excessive in the current climate, but some early clues suggest that countries that have boldly embraced Keynesian policies are setting themselves up for failure, as a recent Bloomberg article suggests:

The U.K. has produced notable economists over the years, but John Maynard Keynes, the guru of government intervention, was one of truly global significance.

So it may be fitting that the U.K. will also become the deathbed of Keynesian economics.

Britain has been following the mainstream prescriptions of his followers more than any developed nation. It has cut interest rates, pumped up government spending, printed money like crazy, and nationalized almost half the banking industry.

Short of digging Karl Marx out of his London grave, and putting him in charge, it is hard to see how the state could get more involved in the economy.

The results will be dire. The economy is flat on its back, unemployment is rising, the pound is sinking, and the bond markets are bracketing the country with Greece and Portugal in the category marked “bankruptcy imminent.” At some point soon, even the most loyal disciples of Keynes will have to admit defeat, and accept that a radical change of direction is needed.

Finding the balance between enlightened regulation that maximizes the benefits of free market capitalism is akin to searching for the optimal balance between democracy and sidestepping the tyranny of the majority. The definitions, standards and results are forever in flux, which means that there are no true solutions. The idea that a market economy can be "tamed" is naïve, but so too is the expectation that an uncritical embrace of free markets will be politically acceptable and economically viable. Somewhere between those two extremes lies a reasonable balance. Exactly where, and on what terms, is debatable, now and forever.

The great challenge is coming to terms with two halves of the same economic coin: The business cycle can't be tamed, but neither can it be left untended. If this sounds like a paradox wrapped in a contradiction, you're right--it is. Welcome to macroeconomics.