October 7, 2008
WHAT HAVE WE LEARNED?
The rolling crisis that has become the daily routine of late has no obvious and immediate solution, but at least we can be clear about how we arrived in this thankless position. And maybe, just maybe, we can learn a thing or two about policymaking for the years ahead. It won't be easy, but progress never is, especially in the dismal science.
Facing up to reality offers no silver bullet answers, but ignorance will only aggravate our troubles in the future. With that, let's acknowledge that the current mess is the consequence of years, perhaps decades of mistakes and short-sighted policies. The list is long, and the details complex. Volumes will be written about how policy makers stumbled. For now, we'll revisit one issue that this observer believes has been central, though hardly alone in the buildup to the problems that afflict us.
Arguably one of the bigger missteps flows from the idea that the economy can be reengineered and manipulated so that recessions are a thing of the past. For quite a while it's been tempting to think that the Federal Reserve and its counterparts around the world figured out how to smooth out the rough bumps in the business cycle. Viewed through the perspective of history, the Great Moderation looked like the answer to every central banker's prayers. The goal certainly was a populist winner: recessions that were less frequent, less painful and perhaps even a vestige of a bygone era. For a while, the impossible seemed possible. A look over the history of business cycles certainly gives that impression via fewer, less painful downturns. That appeared to be the new world order, and the assumption was that the retooled cycle rules could go on forever. The tech bubble burst early of 2000-2002 was a warning shot, but most chose to ignore it, in part because for all the pain of that episode, consumer spending never really suffered, thanks to Greenspan's Fed.
But the kinder, gentler cycle was a myth. Rather than dispensing economic pain to the dustbin of history, it was only pushed into the future. The Federal Reserve has spared no expense over the past generation in pre-empting the first sign of trouble by cutting interest rates and creating liquidity first, and asking questions later. Never mind that the policy promoted debt and greater risk taking. It seemed to work, with no apparent price tag.
Politically, this has been popular, as of course it would be. There is no constituency for recession; there is no lobbying group calling for the cleansing action that comes from corrections. But while no one wants economic pain, inevitably it comes. Preventing the beast from emerging, or moving heaven and earth to moderate it, eventually creates bigger trouble down the line.
The reason is partly tied to the fact that humans make mistakes. As a result, money is lost, companies close and people lose their jobs. That can't be legislated out of existence any more than gravity can be banished from the Earth. Fortunately, loss is the exception, which is why the world economy tends to grow over time. The net change in GDP is positive in the U.S., and for the planet generally in the long run. That's a direct function of the innovation and productivity that arises from Mother Earth's workforce. But for all of that, we're not perfect. Not every investment is profitable; not every company endures. Capital destruction isn't pretty, but it's familiar and it's inevitable. Luckily, it's relatively rare. But rare isn't nonexistent.
As such, neither is financial pain. Shareholders lose their investment, perhaps all of it; workers lose their jobs; etc. That's a problem if your investment was defined exclusively in shares of a failed company. Of course, diversification easily solves that problem. As for unemployed workers, well, that's more complicated, but there are two main issues to consider. One, jobless benefits in the short term help smooth over the rough edges of cycles. Two, promoting and nurturing innovation and productivity in the economy improves the odds that eventually the unemployed will find new opportunities. That's not a dream; it's reality, which is why the blacksmithing industry is gone and software engineering is prospering.
Nonetheless, there's a fine line between promoting economic growth and preventing recessions. Yes, we want lots of the former, but going too far in search of the latter may at some point create more problems than it solves. The rubber band only stretches so far, much as we'd like to think otherwise.
To be fair, it's not obvious where healthy central banking stops and ill-advised cycle engineering begins. But there is a tipping point, and simply recognizing its existence is the first step on a thousand-mile economic journey. And for all our criticism of the Fed, it should be recognized that central banking in this country, and in many countries around the world, has improved considerably over time. But what we don't know about intelligent central banking and how it interacts with business cycles still exceeds our collective wisdom. Progress arrives, but it's painful. As recently as the 1970s, remember, the economic chieftains of the Fed believed that economic growth flows directly from printing money. Learning that lesson wasn't easy, but it was necessary.
What, then, are the lessons in the here and now about the limits of trying to preempt, forestall and otherwise sidestep the natural course of business cycles? No, we don't have definitive answers or detailed policy prescriptions, nor does any one else, at least not yet. Trial and error is still the only game in town, and that's a tough way to gain insight. We can do some of it, much of it on paper, but some of the answers will only come from the field.
Meantime, this much is clear: the previous 20 years of sparing no effort to avert cyclical pain, with no thought as to the outcome, has a price. We'd all like to think that the tactical plan of injecting morphine into the economy to keep everyone feeling happy incurs no pain. But that's a fantasy. Moral hazard eventually has real world consequences. Inhibiting macro corrections in the short run isn't a long-term solution, at least in terms of pursuing the goal without recognizing its limitations.
The hope that consumer spending would always grow, via debt or other means; the desire to see home prices continually rise; the expectation that stock prices will never suffer prolonged corrections; etc., etc., etc., has come to an end. But the game couldn't roll on indefinitely. Perhaps our biggest problem was simply thinking otherwise.
The great challenge for the years ahead is finding a reasonable balance between promoting growth and prosperity while allowing a prudent degree of excess trimming. This is a political question as much as it is an economic one. But answer it we must, and that starts with recognizing what's gone wrong.
In some ways, we've come full circle since the creation of the Fed. Recall that in the early 1930s, the policymaking bias was standing back and letting the market heal itself. (Actually, the Fed negatively intervened in the early '30s with monetary tightening, but that's another story). By contrast, in the last 20-plus years, the Fed has been aggressively intervening in an effort to manage the business cycle in an effort to keep everyone happy now and forever. Is there a third way?
No, we're not saying that recessions should be left to run their course. We've learned too much over the last 80 years to go back to that. But we must also recognize the other extreme, and its subtle but ultimately painful consequences that pop up eventually.
As we ponder the question how to proceed, there's no doubt that the business cycle is having its way with us now, reminding that the we weren't as clever as we thought we were. The good news: the long-averted cleansing will one day give way to a stronger, more robust cycle of growth. But first we have to survive the correction.
Posted by jp at October 7, 2008 9:55 AM
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Posted by: steve at October 13, 2008 10:48 PM
We've come full circle, but not in the way that the author suggests. The Federal Reserve intervened, along with the government in general, during the Great Depression just as surely as it is now, and today's intervention will have the same result as then if not stopped. Back when we had market self healing, when we had true free markets, the panics were short and growth resumed once malinvestments were trimmed away. That is why the period of the late 1800's was the period of greatest economic growth in the nation's history and the era, the great Guilded Age, which made us a superpower.
Posted by: Pliny at October 8, 2008 10:51 AM