Policies aimed at economic stabilization do more harm than good. Macroeconomic policy should be focused not on stabilization, but on economic growth.
Miron: Today’s topic is macroeconomics. Beyond the types of regulation that we discussed a few lectures ago, governments intervene greatly in the overall economy, conducting what are usually called macroeconomic policies or stabilization policies, things like Keynesian fiscal stimulus, monetary expansions and contractions and so on. These policies are potentially enormously important, precisely because they are macroeconomic policies. They affect the whole economy. So if they were done well, that could of course be really good. And if they’re done badly, that can be really horrific because they simultaneously have an impact throughout the economy as opposed to many regulations which, however good or bad they might be, are targeted only at specific industries, sectors, and so on. And macroeconomics has received huge attention recently because of the Great Recession in 2007 through 2009.
Macroeconomics is also especially interesting because it is less settled than many aspects of economics. So that leaves lots of room for quite heated debate over what the right policies are. All economies basically work at stabilization and trying to undo the fluctuations, the ups and downs that we observe in market economies, the recessions, booms etc. People seem not to like variance, volatility, whatever you want to call it.
The consequentialist view, the libertarian view says of course, all other things equal, volatility is probably something we would like to avoid, but the attempt to eliminate it is going to do far more harm than good. And it’s not entirely clear that we should be eliminating all types of volatility. Plus we might want to focus on some other things rather than the volatility by itself.
I’ll talk about a few different topics within this general category. First discuss stabilization policy and the main components, monetary policy, central banks determining the money supply and then Keynesian fiscal stimulus. Then I’ll talk about assessing the overall fiscal situation of an economy, its debt, deficit, fiscal imbalance, and what those mean and how we should think about that. And then I’m going to talk about economic growth, the average rate at which an economy gets bigger over time, and argue that that should be the crucial focus of macroeconomic policy, not stabilization. And fortunately, almost everything that be helpful for promoting economic growth involves less government, not more government. So there’s a natural symbiosis between the focus on growth and a small government in libertarian perspective.
Turning first to general stabilization policy, most market economies try to reduce the variability that seems to occur and seems to be reasonably inevitable. That desire to reduce recessions or eliminate recessions, to have the economy go smoothly, is of course understandable. But there are a number of important caveats. First of all, smoothing, getting rid of that volatility isn’t necessarily desirable. There can certainly be some types of variability in the pace of economic activity that makes sense. They are perfectly rational, efficient responses to underlying situations. If you think about any individual, you don’t work at the same pace every hour of every day, every day of every week, every year of your life. There are ups and downs within the day, within the week, and so on and so forth. Likewise, every industry has ups and downs related to new product development, the lifecycle of its founders, and so on and so forth. Some of that of course will average out in an overall economy because some things are booming while other things are contracting. But there’s no reason to think that the efficient response to new information, to new inventions like the Internet or the digital revolution should necessarily just happen in a smooth way. There could easily be some booms and busts that are economy’s response to incorporating these things and that we should allow to happen rather than trying to smooth them out.
A different issue with the focus on stabilization and eliminating variability is that it distracts attention from focusing on growth. It distracts attention from focusing on the details of what goes into changes in spending and changes in taxes. Those variables, overall spending and taxation, may well have these macroeconomic facts that you’ve probably read about in any standard economics textbook. But they also have microeconomic effects. It matters whether increased spending is on something reasonably productive like a new road that might be useful, or digging ditches and filling them back up, which the standard Keynesian framework says is just as good as building a new road. Which kinds of taxes are raised or lowered matters. The structure of taxation matters. So the focus on stabilization tends to distract from thinking about the details, thinking about growth, and thinking about the composition and the nature of government spending and government taxation.
The focus on stabilization and the knowledge that the government is going to be engaged in all these stabilization efforts creates a source of uncertainty that wouldn’t be in the economy if the government just said, “We stand by and watch what happens, period, end of story.” Under the current environment, everybody not only has to try to guess is there going to be an oil bust or boom? Will that affect the economy? Is there going to be an Internet boom, how will that affect the economy. They also have to guess how the government is going to respond to all those things. And that’s a new source of uncertainty that may do as much damage by itself as the other sources of shocks to the economy and certainly makes it more difficult for private actors to figure out what’s going on and to make appropriate responses.
Setting aside all those possible caveats to whether it’s desirable to try to undertake stabilization policy, the history and the evidence says very clearly that it’s not easy to do. Why? Mainly because the lags between any attempt to smooth the economy and the effects of those actions, those lags are long and variable. That’s a line due to Milton Friedman 50-60 years ago, but it’s just as important now as it was then. If you’re trying to keep your car going at a very, very even keel and go around every single pothole, you may end up having to careen across the road to avoid the potholes. If you don’t recognize that you need to adjust calmly, you may be slamming on the brakes when you should be accelerating ahead. We can’t forecast overall economic activity very easily. So we don’t know what we should be doing in terms of our attempt to stabilize. Should we be pushing harder to make the economy grow? Or should we be slowing down because the economy is overheating? That means that policy is going to add a lot of volatility to the pace of economic activity rather than just reducing it – which it may do in some cases, but that’s certainly not the entire story. So stabilization policy is hard to do whether or not it’s desirable to do.
Looking into the details a little bit, one aspect of stabilization policy is monetary policy. Should we have a Fed, should we have a gold standard, should we have some other kind of central bank, and so on? In particular, what is the best monetary system? I would emphasize that figure that out is really, really hard. Economists don’t have such great theories of why money really exists in the first place, let alone which monetary system is the best. There are lots of reasonable things one can say in favor of fiat money. Lots of things one can say in favor of gold standards. Reasonable things to say in other types of overall monetary systems. Both, in fact, fiat money, standard stabilization policies we’ve had under the Fed, or a gold standard, are government trying to fix a particular price in the economy. And that is likely to lead to some potentially counterproductive effects because fixing prices is not necessarily a good thing. Economics generally says when prices are flexible, that allows economies to equilibrate, that allows things to adjust in a reasonable way – specifically with respect to gold versus the Fed, particularly the post-World War II Fed, the evidence is incredibly unclear. If anything, it makes a slightly better case that the Fed has done a better job than we had under the gold standard, despite the seeming a priori appeals of having something automatic, which is what a gold standard is meant to provide us. So neither a priori reasoning nor the evidence says clearly that one system is better than the other. It’s something that still needs further study and still will be debated for a very long time.
Note that there are other aspects of the monetary system that could be improved dramatically regardless of what the overall system is. So allowing something much, much closer to free banking makes sense whether there’s a Fed or not, whether there’s a gold standard or not. Much less regulation in the financial sector is almost certainly desirable, regardless of what you think the overall monetary system should be. Last comment on that, if you could discipline your economy to pick a monetary system and stick with it, to pick a rule and stick with it, rather than all of the intervention that we experience under central banking, there would be a case for some sort of fixed growth rate, of some monetary aggregate as a way of stabilizing the economy or at least avoiding adding volatility to the economy. In particular, if you had the economy just have the monetary base grow by 3 percent a year for every year going into the future and you could commit to sticking to it and you actually stuck to it, that probably creates a stable environment around which a private sector could develop a banking system that avoided panics, at least large panics, and the negative things that are associated with those.
Turning to fiscal stimulus, there are two main arguments for why we should expand spending. One of those arguments says that particular spending is desirable on cost-benefit grounds. Another bridge might be useful between two particular cities because traffic could flow more easily on a super highway and so on and so forth.
Second argument is that we need to expand spending during recessions because that creates extra aggregate demand in Keynesian framework that helps pump up the economy by generating more demand for goods and services. And it doesn’t matter whether that spending is productive or not. As long as you spend more money, whether it’s on something inherently worthless like building toaster ovens and throwing them into the ocean, that’s still good for the economy. Now if the first thing is true, if there’s additional spending that passes standard cost-benefit tests, then of course it’s defensible. The government should undertake that. If that’s spending that the private sector won’t do for some reason, then we can certainly give a few examples of things like that. But that’s really independent of stabilization. That just says if there are new roads that ought to be built, if there’s additional spending on the military, if there’s some schooling or subsidy for education, that does in fact pass cost-benefit as a government project, then there’s a plausible case for doing that. It doesn’t have anything to do with recessions. The argument for the stimulus spending that’s controversial and that we really have to think about is that we should spend more regardless of what it’s on, regardless of whether it’s really productive, in order to help prevent recessions.
On that point, there is a model that makes that claim: the standard Keynesian model, the aggregate economy. The evidence to support that proposition of the Keynesian model is incredibly weak. It does not show that extra spending systematically helps get economies out of recession. It does not show that cutting spending systematically causes economies to tank. It shows that the change in spending has relatively little to do with the fluctuations in economy. So empirically, that proposition doesn’t get much support regardless of how convincing or appealing you find it on a priori grounds.
Related to that, the evidence does suggest that changes in taxes do have big effects on the overall economy. And at some level, that’s comforting because the standard Keynesian model would support that proposition. Cuts in taxes stimulate the economy, increases in taxes tend to retrench the economy, and standard microeconomics that higher tax rates reduce people’s incentive to work, save etc. also would lead you to exactly the same conclusion. So both consistently across theories and consistently across evidence, if you’re going to engage in stabilization, tax policy seems like the better way to go.
That leads to a little bit of discussion of the overall fiscal situation of major economies. There’s of course decent amount of worry in all those economies. In my view, much, much less than it should be, but a lot of worry about the debt deficits and so on. The key thing to note is that the debt or the deficit are both incredibly incomplete measures of an economy’s overall fiscal position. An economy could have very little explicit debt and still be in very bad shape because it was going to grow slowly and because it committed to lots of expenditure in future. Likewise, you could have a very high ratio of debt to GDP at a moment in time and yet be in fairly good shape because your economy was expected to boom and because future expenditures were not scheduled to be particularly large.
The U.S., at the end of World War II, is a classic example of that point. We had huge debt because we had spent an enormous amount on the military in World War II. But everybody expected that spending to decline dramatically once the war was over, which it did with a slight blip up for Korea. But it overall declined dramatically over the next several decades. Everybody thought the economy was in good shape and would continue to grow. And indeed, the U.S. debt ratio came down enormously.
To take account of all those things, we need a different measure than the debt or the deficit. We need what is usually referred to as a measure of fiscal imbalance, something that takes account of all future expenditure and all future potential for tax revenues. When you calculate those for the main economies in the U.S., Europe, Japan, and so on, you find that there are huge fiscal imbalances. The amount of expenditure promised for government savings programs and government health programs are enormous relative to any plausible amounts that those governments could collect in taxes over the infinite future. Therefore, those economies need to do something in order to adjust their situation. Otherwise, they will be Greece. They will end up simply unable to pay their debts.
What should you do about that? One view is that we need something like a balanced-budget amendment. As libertarians, we should be appalled at the notion of a balanced-budget amendment because you can balance a budget in two ways: by cutting spending or by raising taxes. And libertarians have very strong view about which of those two is the right approach. So spending-limitation amendments may or may not be super effective. Politicians may find ways around them. But at least spending amendments, other types of spending rules, are in the direction that we want, which is get the spending down relative to the state of the economy. It is of course hard to cut expenditure. Most of the expenditure that’s the problem is for programs that are really popular; that’s part of why there’s a lot of expenditure there. To some extent, Social Security, although that’s relatively minor, much more in Medicare and Obamacare and Medicaid. Those programs are the ones that are large and growing at the fast rates that are creating the huge fiscal imbalances. They are sufficiently large that economies need to do something. All these rich economies are in similar position. They all need to do something. They won’t be able to grow their way out. They won’t be able to tax their way out. They have to cut the expenditure. And ideally, they do it sooner rather than later.
The last point to make in thinking about overall economies, macroeconomics, is that they would do far better to focus on growth rather than trying to moderate business cycles. Even a small change in an economy’s growth rate accumulates over time so that over 10, 20, 50 years, a 10 percent increase in the growth rate or 25 percent increase in the growth rate, even smaller amounts, add up and lead to very big changes in the standard of living. So growth is really important if there are things economies can do to promote growth.
For a country like the United States, there are almost certainly some things. It’s hard to determine exactly how much they will do. But fortunately, almost all those things are incredibly desirable anyway. So freer trade is a no-brainer. It will help the economy be more productive. It will help the economy grow. Ideally, we should do it unilaterally rather than waiting through all the delays that occur in multilateral trade bargaining, although those are probably better than nothing.
Expanding legal immigration could have enormous productivity effects for the United States, for lots of countries. Even fully open borders, the libertarian ideal, that would allow reallocation of labor from countries where it’s less productive to countries where it’s more productive. That’s in fact in everyone’s interest. It would be good for growth not just the United States but everywhere.
Simplifying the tax code is an enormously sensible thing to do to promote a faster growth because it would mean people are spending times doing productive stuff, not spending time trying to figure out tax arbitrages that can allow them to improve their after-tax profits by rearranging how they do things for tax purposes as opposed to rearranging how they do things to make better products and to earn higher profit.
A better patent system might play a non-trivial role in U.S. productivity. There are a lot of kludgy things about the current U.S. patent system. Probably, the right approach is to have a less aggressive patent system. But we’ll talk about that in a later lecture.
And of course more generally, there are huge amounts of environmental regulations, safety regulation, financial regulation, and so on, that is adding cost, putting grist in the mill, and slowing growth of the U.S. and other market economies. If any of those improvements lead to even small changes in an economy’s overall growth rate, that will add up to enormous improvements over time.
To sum up this discussion, macroeconomics is hard. The fact seems to be that things go up and things go down pretty much independent of what governments try to do about it. So figuring out a way to make it go down isn’t easy, it’s not necessarily desirable, and attempts to do so tend not to be so successful and have their own cost. It would be much better to stop worrying so much about business cycles and moderating fluctuations, to let the ups and downs occur. And they’ve occurred at similar rates for long, long periods, whether or not governments were involved in trying to stabilize them. So it’s not clear they would be any worse if governments just left them alone. It would be far better instead to focus on growth. It’s not trivial to improve growth, but there are a bunch of simple no-brainer policies that the U.S. and many countries could adopt quickly that would certainly go in the right direction. Thank you very much.