To Recover, We Must Abide By Classical Principles

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Disagreement over federal rescue plans arises from legitimate doubts. Ever larger interventions that fail to restore normalcy have made the public wary about Washington’s rush to spend our way out of the financial crisis. As within any panic, knee-jerk responses by the powers that be are politically unavoidable. But it would be more productive

to take a step back and regain perspective.

Classical economics and common sense can provide clarity and a more helpful – and restrained – approach to weathering the storm. The average economist pays lip service to classical precepts that are misunderstood or neglected in practice and often supports government actions that directly conflict with them.

Nearly all of Washington believes that spending drives the economy – that “demand” drives “supply.” But central to classical economics is the more subtle idea that demand and supply have a mutual interdependence like the two inseparable sides of a coin. To keep the economy moving, both must fire simultaneously. The fuel is effort and enterprise, including management talent, innovation and risk-bearing. It is not money or credit. These are akin to lubrication, only a minimal amount of which is necessary for the economic machine to operate. The economy does not grow proportionately with the amount of money or credit in the system.

According to classical economics, the necessary economic fuel is not threatened by a credit crisis; but uncertainty and fear keep it from finding its best use. State initiatives tend to increase uncertainty and were exactly what the early classical economists distrusted, influenced by scientific discoveries of equilibrium systems in nature. John Stuart Mill pointed out that economies heal themselves following violence and destruction. So does the human body. Good physicians know their job is to facilitate self-healing, not to thwart it.

Public-sector interventions elicit adjustments in the private economy that reduce or nullify their purpose. Indeed, economic systems automatically resist outside disturbances as do physical and chemical systems. They go by LeChatelier’s Principle: “A change in one of the variables that describe a system at equilibrium produces a shift … that counteracts the effect of this change.” This is exemplified by two classic economic phenomena: “crowding out” and substitution. The scope for substitution is often ignored in modern discussion; one example is the fear that banking is an irreplaceable pillar of the economy. More realistically, if money and credit are not forthcoming from the banks, other pools of capital will spring up as substitute sources.

Fear for bank solvency has motivated researchers to try to estimate the “lost wealth” due to the crisis, and from that they derive a prognosis for the economy. Will the world’s banks have to write off $2 trillion ultimately, as officially estimated? Or is the loss closer to $3.6 trillion, as suggested by some who forecast a sustained economic collapse?

Yet the presumption that lost wealth depresses economic activity flies in the face of a common-sense idea embodied in the following question: Do you make people work harder by making them richer – or by making them poorer? The answer, surely, is by making them poorer.

Another false assumption is that any problem can be solved if enough money is thrown at it. The classical, and wiser, observation is that the more money lavished on a problem, the bigger that problem is liable to get. The Romans eventually succumbed to the barbarians they tried to buy off.

Just as classical economics was spawned in the Enlightenment by revulsion to autocracy, conventional macroeconomics derives from the desire to place the State back in economic control. Following World War I and the onset of the Great Depression, John Maynard Keynes deprecated market forces, and the intellectual case he reintroduced for government intervention and management was seized enthusiastically.

Keynes caused a rift between modern macroeconomics (the theory of aggregate income, employment and money) and standard economics (price theory). Students of both often admit to a feeling of schizophrenia. In standard economics markets clear through the adjustment of prices, and equilibrium is constantly being regained. But according to modern macroeconomics, prices don’t adjust. The markets for income and employment stagger from one disequilibrium to another, periodically requiring redirection by government.

Keynes’ critics pointed out that government spending in the 1930s did not succeed in normalizing unemployment, which was still over 17 percent in the US in 1939. Nevertheless classical economics was thought to have failed. Keynesian ideas and teaching tools eventually acquired a near-monopoly in the classroom.

The premise for today’s policies is that the Depression resulted from a banking crisis that the Federal Reserve failed to address. This requires us to believe that non-bank firms are unwilling or unable to substitute for banks compromised by the threat of insolvency. True, it takes trust for new credit relationships to develop; that could explain a recession, but not a depression. Surely the explanation for the Depression lies elsewhere.

Classical economics does not, in fact, rule out sustained slumps. An act of government that hamstrings the price system, deters the private sector from exercising enterprise, or curbs its freedom to trade will hold the economy down until such policies are changed.

According to yet another classical precept, the size of an economy depends on the scope of the market that its participants can reach. Globalization increases that scope, while protectionism cuts it back. Thus sustained closure of world trade could be enough, by itself, to hold the world in depression.

The mystery about the Depression is why it began when it did and why it ended so abruptly. In the Wall Street Journal more than thirty years ago, the late Jude Wanniski pointed out that the 1929 Crash occurred at the same time – to the day – that President Hoover decided to sign the Smoot-Hawley tariff. Following large-scale retaliation on the part of US trading partners, world trade collapsed. Sustained peacetime growth did not return until 1945 – shortly after the Allies agreed to restore free trade at Bretton Woods.

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