If only the government would get out of the way, then the private sector would blossom and the economy would repair itself. This is a view that his held by many, including many economists. It is based on a view of the market economy that is self-correcting and self stabilizing, a flexible price mechanism that clears markets more or less instantly, and economic agents behaving rationally.
While one doesn't have to take the perfect world of the Arrow-Debreu (which depends on a series of highly unlikely assumptions) model face value to point to evidence that seems grosso-modo supportive. Free market economies have produced more wealth than other forms of production. It is as simple as that.
When China started reforms, first in agriculture and then establishing free-trade zones and expanding markets, private property and entrepreneurship, the economy took off. But what should be kept in mind is that China, like Japan before it and despite its spectacular economic growth, is pretty far away from being a free market economy.
While we certainly think that grosso modo, the evidence is supportive of the superior wealth creation of free markets, but we've always argued that their supporters have too little attention of some of the failings of markets, taking them almost as an end in themselves, rather than a means to an end (economic prosperity).
That makes many of them blind to the way government can actually improve market outcomes, that is, offer solutions of some of the market failings, rather than being cast as the problem by definition.
Adherents of the free-markets school of economists believe that the economy is self-stabilizing, that after a shock it will more or less quickly re-establish "equilibrium," meaning more or less full employment of resources. If only the government gets out of the way, all will be fine. Let markets perform their magic.
This vision of the self-stabilizing nature of the economy where resources are always more or less fully employed and the private sector activity quickly fills the a retreating government leads to a number of predictions that sit uneasy with reality.
Government deficits crowd out the private sector
If resources are always more or less fully employed, public sector expansion must, by definition, come at the expense of the private sector. One (but only one) of the ways this can happen is public deficit spending driving up interest rates. Here is historian Niall Ferguson in May 2009:
only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert "no upward pressure on interest rates."
The planet Econ-101 that Ferguson was ridiculing here was embodied by Paul Krugman, with whom he had a very public debate on these issues back then. He argued the following in May 2009:
So what does government borrowing do? It gives some of those excess savings a place to go - and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.
Three years on, this debate seems to have been settled well and truly in favor of "economics-101" (despite Ferguson's rather embarrassing premature victory cry at the time).
Those "excess savings" that Krugman mentions are not possible in the market clearing model of the economy that underlies the thinking of the free-marketers. Here is Eugene Fama:
bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.
Short-term interest rates
Well, in order to stimulate those private investments that Fama fears are having difficulties finding funding, how about embarking on expansionary monetary policy to induce the interest rate reductions to foster private investment?
As it happens, this has already been done. Rates have been slashed all the way to zero and the Fed has embarked on several rounds of unorthodox measures like quantitative easing (QE). Here is our favorite economist, Richard Koo from Nomura:
If central banks bring interest rates down to almost zero and nothing happens then it is not an ordinary world. (FT)
Indeed. When banks and households will do everything possible to deleverage their balance sheets and pay down debt - even when interest rates are near zero, then we're not in the ordinary world of a self-stabilizing economy were resources cannot remain idle for long, but we're well within the territory of a balance sheet recession, which Koo developed. But there is more that the self-stabilizing view of the economy has a hard time explaining.
Those unorthodox monetary measures like quantitative easing by the world's central banks have failed to set off even the mildest acceleration in inflation. Indeed, when these policies were pursued in Japan (2002-2006) under similar circumstances, the country continued to suffer from deflation, rather than inflation.
In a world where resources are always more or less fully employed and economic equilibrium is relatively quickly restored (as long as the government "gets out of the way"), this simply cannot happen. There would be "too much money chasing too few goods," as the saying goes.
But there is more.
Guess what? The public sector IS retreating
In an important article for the Economic Policy Institute, Josh Bivens and Heidi Shierholz show that
while jobs fell much further and faster during the Great Recession than in the previous two recessions (marked by the lines to the left of the zero point on the x-axis), job growth in the current recovery is similar to job growth by this point in the previous two recoveries
They note that the one feature that is striking is the loss of public sector jobs in this recovery, which is an entirely different experience to the public sector job gains in previous recoveries:
(click to enlarge)
The direct loss of public sector jobs since June 2009 has been 627,000 jobs, but they're right to point out that this significantly underestimates the drag on the economy. They argue that because of population growth, there should have been public sector job gains, not losses. Had the ratio of public sector employment to the overall population been constant as it has been since the 1980s at 7.3 public sector workers per 100 people in the US, it would have added another 550,000 jobs.
There are also important secondary effects. Fired public sector workers have less to spend ("teachers and firefighters stop going to restaurants and buying cars if they're laid off") and the public sector itself demands less inputs, and reduce transfer payments.
Estimating these secondary effects and adding it to the primary ones arrives at some 2.3 million jobs lost due to cutbacks in the public sector which, we have to remind you, is contrary to net public sector hiring in previous recoveries.
These public sector cutbacks explain a good deal of the tepid job creation in this recovery. The recovery itself isn't atypical, what was atypical was the steep fall in the crisis, there was unprecedented job destruction in 2008 and the first half of 2009, much more so than in previous crisis (bar the Great Depression of the 1930s).
We could add that the government is "getting out of the way" of the private sector in other ways besides unprecedented reduced public sector employment. Important tax cuts have been extended and new ones applied, resulting in the Federal tax intake being at the lowest level (15% of GDP) for decades, and one doesn't come away with the impression that US corporations are excessively taxed after having been confronted with the figure below:
One should test one's model of the economy on the available data, and where there are such important deviations from what your model would predict, one should start to question the validity of the model itself. Those that, implicitly or explicitly, work on the assumption that the economy is self-healing and equilibrium self-restoring if only the government would "get out of the way" are faced with many phenomena today that their model cannot really explain.
For years they predicted rising interest rates in the face of large public deficits, runaway inflation in the face of "money printing," wonderful things if the government would just "get out of the way" and taxes would be reduced. None of it has materialized. Why not?
Well, our answer would be that this model of the economy as self-restoring isn't universally valid. Apparently, the economy can be stuck in equilibrium with plenty of unemployed resources, which is the classical Keynesian universe in which the problem is created by a lack of demand, or those excess savings Krugman was talking about in the quote above.
It isn't terribly hard to figure out where those excess savings are coming from. We had an credit infused asset bubble, and when this imploded, asset values plunged but the debt remained, greatly damaging household's and bank's balance sheets. Median family net wealth plunged from $126,400 in 2007 to just $77,300 in 2010, a rather staggering plunge.
In order to repair these, households began spending less, saving more, a process that is still ongoing:
Household debt has now fallen to 84% of GDP from a peak of 98%. Nonfinancial corporate debt has fallen to 77% from a peak of 83%. Financial sector debt has plunged from 123% of GDP to 89%. Public debt has risen to 89% from 56%. (Yahoo)
This is the world of a balance sheet recession, and this model can perfectly explain what's going on, as we've already set out in another article. This doesn't mean that there is no value in free markets (rather the contrary) or a lean government, it simply means that the self-stabilizing model of the economy doesn't apply to the present circumstances in which the economy is stuck in an underemployment equilibrium.
And it applies equally to the policy advice that is based on that model. Much of it (tax cuts, public sector reductions) is already being implemented anyway. So while it's understandable many investors have joined the chorus clamoring for getting the government out of the way, while in general agreement, we urge you to consider the special circumstances of the present condition and the evidence before joining in.
The investment climate is not always and everywhere helped by a retreat of the public sector. There is solid evidence that now is one of these times.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.