During the financial crisis, my perspective has been hardened that the classical economists and even a hard nosed version of Austrianism is the appropriate policy position for practical political economy. I agree with Larry, George and Steve on the technical economics if we had either a free banking system, or if benevolent and omnipotent despots were running the Fed. But precisely because we have neither, I think the political economy position is one that basically focuses on flexibility of the price system and freezing the money supply and not stabilitzing MV. Isn't any supply of money optimal given a flexible price system? And such a system would bind rulers hands by at least taking one policy tool out of their manipulating hands.
Bottom line: I don't think monetary expansion is a way to address a collapsing economy due to previous manipulations in money and credit; I don't think fiscal stimulus is effective in revitalizing an economy for long run growth even if it was the size of WWII expenditures; I don't believe that tax increases will bring fiscal responsibility, etc., etc. A good dose of laissez faire, in my opinion, is the only way out of our economic morass.
Whatever the soundness of those judgements are, it is in a fundamental sense besides the point in our current policy discourse. Let's assume for sake of argument that in the fall of 2008, an activist monetary policy could have avoided the financial crisis (as Tyler and Scott Sumner argue), that a much bigger stimulus could have kick started the economy in 2009 and 2010 (as Paul Krugman and Brad de Long argue), etc. But the fact is that those policies were not followed then, and we cannot go back in time. So rather than discuss what could have been (and whether that would have been the right or wrong path), the question we face now is what are we to do now?
Keep in mind two things --- a loss of credibility by the US government and the key policy makers, and the anticipatory power of individuals that aids in engaging in off-setting behavior (not quite rational expectations and the invariance proposition, but not passive reaction to policy designs either). We cannot assume either of these realities away.
To me all that is left to do is hard decisions for politicians. They cannot reinflate the bubble; they cannot be anymore fiscally irresponsible. Calls for 4-6% inflation would be anticipated by market participants so the monetary illusion assumed would not in practice be in effect. In short, policy makers are trapped by their own policy designs, and the traditional answers only ensnare them further in the trap rather than offer a way out.
Laurence Kotlikoff has been issuing warnings on the coming generational storm due to fiscal irresponsibility for my entire professional career, let alone the warnings that James Buchanan issued from the 1950s throughout his career about the consequences of Lord Keynes and the breakdown of the old-time fiscal religion, see Public Principles of the Public Debt as well as Democracy in Deficit. And, of course, Hayek's warnings about inflation getting us in the end from A Tiger By the Tail should always be heeded. In short, the sort of drastic policy shifts that were offered along with these warnings should be the starting point of any current discourse.
As Jerry O'Driscoll pointed out last week, our situation the political economy legacy of Keynesianism, and it is the Keynesian death spiral we are caught up in at the moment. Ludwig von Mises once wrote that he started out as a reformer, but instead became a historian of decline.
Can we avoid this fate as economic thinkers?