The Economics and Political Economy of Fear -- Stiglitz and Prescott edition

| Peter Boettke |

Alex Tabarrok links together the separate discussion from 2 Nobel Prize winners -- Stiglitz and Prescott -- on how the environment of fear generated both the crisis last year and the policy responses.  Stiglitz says "Economics would have suggested that if you did a debt to equity conversion, converting long-term debt into equity, the financial institution would be well capitalized, there would be no reason to panic, and there would be more confidence in the market. But those who saw an opportunity to use scare tactics to get what they wanted did use those scare tactics, and it worked."  Prescott argues that with "benign neglect the economy would have come roaring back quite quickly..."

What do you think about these fear-based arguments?

I have tried to stake out the position in blog posts and in articles that I have written (and in a monograph that Steve and I are publishing) that a market correction was necessary due to malinvestment caused by previous government policy mistakes (directed by microeconomic distortions in real estate and financial service industry, and fueled by the manipulation of money and credit by the Fed).  But the process of market correction was turned into an economy wide crisis by a variety of government policies designed to prevent the market correction.  In this sense, I do not buy the economics of fear story (i.e., markets are driven by swings of optimism and pessimism), but I do buy the political economy of fear (i.e., strategic use of circumstances to win election and push for favored policies).

The biggest lesson to me last fall was how shallow was the intellectual support for free market policies across the viable political spectrum.  Ron Paul (and a few other Republican members of the House) was really the only politician who got the story right.  Politicians left and right tripped over each other on the way to passing statist legislation.  A Presidential candidate caved completely on the opportunity to offer an alternative to Obama (not that he would have won, but at least he would have went down fighting).  "Yes We Can" (make the US even more statist) substituted at a critical moment for any thought about "Should We Do This".  We need a renewed commitment among a significant segment of the economics profession to research and teach the finer points of the core principles of how a free market economy works and the appropriate political economy for a free people.

The economic consequences for our grandchildren have yet to be fully considered of the policy path chosen last fall, and continued with the Obama administration since the election.  The cycle of deficits, debts and debasement have been set off without constraint,  while the list of government obligations continues to grow --- to engage in effective military action, to meet the growing demands of an aging population, to provide expanded educational opportunity to the young, to control the health care industry, to still promote home ownership (and the idea of the stake holder economy), etc., etc.  Government can only raise revenue in three ways --- government does not create wealth, but must procure it (confiscate it) either through taxes, the hidden tax of inflation, or borrowing (intergenerational theft).  The natural proclivity of democratic governments (unchecked) is to borrow and then inflate to monetize the debt.

Our only hope is not in bi-partisan government, but in divided government which check-mates one another. This was the reason why the Clinton years saw economic growth --- the gains from trade (Smithian forces) and the gains from innovation (Schumpeterian forces) were allowed to outpace the wealth destroying capacity of government (Stupid public policies).  But this was because the pace at which Stupidity was advancing was slowed by divided government such that Smithian and Schumpeterian forces could stay ahead.  Under Bush after 9/11, a form of unified government took hold of Washington, and stupid statism took hold of the policy regime.  This culminated in the complete abandonment of principles last fall as Bush tried to explain why we had to engage in government take-over of industries in order to maintain the free market system.  It is evident in every speech that Obama gives about the need to maintain the free enterprise system while calling for more and more state involvement in health and human services, as well as investment and enterprise.  This "mix" is supposed to provide us with the innovation we get from the lure of pure profit, while also taxing wealth to provide stability and security.  Unfortunately, the promises belies the reality of incentive incompatibilities and the informational distortions in resource use that result from such government involvement in the economy.

Market behavior is not fundamentally about psychology, but about the interaction of underlying realities of tastes, technology, and resource availability and their reflection in property ownership, movement of prices, and the bottom line of profit and loss.  The interrelationship between the underlying realities and the market reflection of those fundamentals is impacted by government policies that determine the environment within which this relationship is worked out.  Government intervention in the form of taxation, regulation, nationalization, inflation and financing only distorts the relationships and results in an alternative set of incentives and a different informational signal than what would have been the case if the free market system was able to operate.  Fear doesn't determine the market, but fear can determine the politics of the moment, and the politics of the moment in turn dictate the enviornment within which economic activity takes place.  Thus, the channel through which fear impacts economic performance is revealed.

Last fall (and since) this has been on full display as a market correction was turned into an economy wide crisis by the fear-induced politics of the moment that were designed to prevent the market correction.  It is very difficult to imagine given the electoral incentives and the lack of reliable information about economic activity that politics can provide that we will get principled politicians when it comes to sound economic policy in the near future.  Instead, all we can hope for is divided government so that the two sides check-mate the excesses of one another, and the Smithian and Schumpeterian forces can outpace the Stupidity of government.  Right now, Stupidity (on both sides) is unfortunately in the lead.

Comments

[Mike M]

Peter you have it right. As I talk to politicians I always am amazed by two facts, first they do not economics and second they do not understand hat the economy sooner or later must pay the price for their misallocation of resources.
Sooner or later the economy will have to adjust postponing the inevitable does not solve the problems just forces someone else to deal with the issues.

[Austin]

$4/gallon gasoline pushed many consumers to the tipping point, as domestic drilling was on the political table, and investment in alternative forms of energy was greater than perhaps at any other time in history. "Health care reform" has so many people vexed with government in general that we have thousand-people marches on D.C.(9/12), and Texas even breathed a breath of cessation from the Union. Let's not forget that any climate change bills are off the table for the near future. People are angry.

With this said, Pete, I agree that the best Washington is a divided Washington. But that's also only if we seek to keep things as they are. But wouldn't it almost be better if there wasn't a divide, if government could run amuk, thus pushing people even farther (hopefully to a Texan extent)?

I don't mean to go psycho-anarchist on your blog, but with our current political system, it seems like we only receive real change when people get really upset. I question whether the short run gains that come with a divided Washington outweigh the long term possibilities.

[Jeremy]

In our times I find it's best to lighten the mood about the state of the economy with this :) http://www.youtube.com/watch?v=gACEVoqT7cY

[Bill Woolsey]

Pete:

The connection between fear and macroeconomic disturbance is a failure of the real quantity of money to adjust to the demand to hold money. Or, equivalently, the inability of the nominal interest rate on low risk, liquid assets to turn negative (which, matters because it impacts the demand for money, as above.)

If all prices were perfectly flexible, and, perhaps, because of this, long term nominal contracts weren't important, then fear might impact the allocation of resources (consumption rather than investment, leisure rather than labor, backyard bunkers rather than vacations) but they would not result in what always looks like excess supplies of resources, including labor, pretty much across the board.

Sumner and I (and I think Selgin, Horwitz, Garrison, and White) pretty much agree that an increase in the nominal quantity of money can substitute for unrealistically flexible prices and will avoid disrupting nominal contracts to boot. That doesn't mean that fear won't impact the allocation of resources.

After Bush and Paulson spoke about the financial crises, a majority of Americans thought that another great depression was either somewhat or highly likely. What is the rational response to that irrational belief? What is the market process that coordinates those actions with fundamentals of scarcity?

Of course, it would be bad if people foolishly decided to switch to part time paid employment to work on their home gardens. But that would imply a shortage of labor. If people pulled their money out of banks and spent it on rifles and ammo, firms would hardly be able to upgrade those networks, but the armaments industries would boom.

But we have a monetary economy. And if fear causes people to demand more money, the market solution is lower prices and wages, and the signal provided that these changes need to be made are surpluses of products and resources, and labor, across the board. And because nominal contracts are all partly speculations on the purchasing power of money, this is going to result in the real costs of bankruptcy.

[Peter Boettke]

Bill,

Look you have forgotten more monetary economics than I can remember. I agree with you that in theory, if the demand for money increases there has to be a change in the quantity of money to offset. But I really cannot wrap my head around the Sumner idea that the Fed has been too restrictive the past 12 months, and that what we need to worry about now is that the end game of this monetary policy path is not possible to negotiate in a way that will get us "back on track".

But I just don't see the real economy has being "completely" determined by expectations. I see a role for expectations (and important role), but ultimately it is the dovetailing of the underlying variables (tastes, technology, resources) with the induced variables (relative prices and profit/loss) that governs market activity unless there is intervention which steers us in wrong directions (which we must come back to the more correct path).

What am I missing in this story?

Pete

P.S.: I think it is great that you are blogging as I think you have written some of the most insightful stuff I've read over the past several months.

[Lee Kelly]

It seems to me that resource misallocation precipitates fear-based crises.

There are more ways to misallocate than not; we shouldn't presume that a reallocation will not just be another misallocation. There are a narrow range of sustainable reallocations, and the market has to discover at least one of them. Unfortunately, the original misallocation produced illusory price signals, and so there is a lot of unlearning that must occur. Once investors realise how little they understood before the bust, the future starts looking unpredictable, and, for investors in particular, that's very scary. The government just sits on the sidelines encouraging everyones' worst fears, (and then promises to protect people from unpredictability).

In any case, it seems to me that people who focus on fear are not wrong to be concerned with it, but are just looking at one link in the chain.

But what do I know ...

[Cheap Jordans]

IT IS hard to look at the Capitol in Washington, DC, without a frisson of excitement