A Plan to Restore American Prosperity

On February 8, 2012, in economic theory, Federal Reserve, monetary policy, by Jon Lewis

First Principles: Five Keys to Restoring America’s Prosperity. John B. Taylor. W.W. Norton & Company 2012, pp. 235, $24.95 Unless something dramatic happens in the Persian Gulf, this year’s presidential election could very well hinge on the unemployment rate in November 2012. While January’s unemployment numbers had to have been somewhat encouraging for the White [...]

First Principles: Five Keys to Restoring America’s Prosperity. John B. Taylor. W.W. Norton & Company 2012, pp. 235, $24.95

Unless something dramatic happens in the Persian Gulf, this year’s presidential election could very well hinge on the unemployment rate in November 2012. While January’s unemployment numbers had to have been somewhat encouraging for the White House, a recent poll nevertheless revealed that only a mere thirty-six percent of Americans say President Obama is doing a good or an excellent job handling the economy. Many Americans, particularly those who understand the extent of our debt crisis, continue to be wary about this country’s economic outlook.

In First Principles: Five Keys to Restoring America’s Prosperity, John B. Taylor (Stanford University) presents his strategy to restore American economic greatness. According to the author, our current economic problems stem from its getting away from the basics of what made America great. “The premise of [First Principles],” writes Taylor, “is that the best way to understand the problems confronting the American economy is to go back to the first principles of economic freedom upon which the country was founded.” The author defines economic freedom as meaning the freedom to decide what to produce, consume, buy and sell, and how to help others. He enumerates what he considers to be the defining principles of economic freedom as: a predictable policy framework; the rule of law; strong incentives; a reliance on markets; and a clearly limited role for government.

Influenced by libertarian economists Milton Friedman and F.A. Hayek, Taylor emphasizes the importance of policy predictability and the rule of law. “Government’s adherence to known rules,” Taylor contends, “allows people to have a clearer sense of what is coming, and therefore to make more informed decisions about long-range plans.” Indeed, many of President Obama’s critics have complained that the current administration has created an uncertain business climate, making it very difficult for businesses and industry to plan for the future. When one hears echoes of capital sitting on the sidelines, this almost certainly is what is being referenced.

America’s adherence to the principles of economic freedom, suggests Taylor, has been stronger and weaker at different moments in our nation’s history. Policy shifts back and forth between interventionism and an appreciation for limited government. This occurs, “remarkably” according to Taylor, “nearly simultaneously for fiscal policy, regulatory policy, and tax policy.” Whereas the latter half of the 1960s into the 1970s was a time of increased interventionism, the Reagan-Bush-Clinton years were a more an era of economic freedom. This period is generally known as the Great Moderation. The George W. Bush-Obama era, on the other hand, has been a bipartisan era of increased interventionism. Following the financial crisis of 2008, the federal government has been increasingly interventionist with quantitative easing, health care regulations, and the Dodd-Frank financial reform legislation.

Taylor, who most recently served in the George W. Bush Administration, rightly acknowledges that members of both parties have veered away from an adherence to economic freedom. His assessment of how differing chairmen of the Federal Reserve performed deserves particular attention. Paul Volcker, best known for quelling rising inflation during the early years of the Reagan Administration, is presented as someone who intuitively understood the importance of economic freedom. Volcker’s near-singular focus on combatting inflation stands in stark contrast to Ben Bernanke’s monetary activism. With regard to the best-known Fed chairman, Taylor presents Alan Greenspan as someone who, in 2003-2005, purposefully moved away from the previous decades’ predictable rules-based monetary policy.

The author devotes individual chapters to the looming debt crisis, crony capitalism, and entitlement reform. Given his expertise in monetary policy, Taylor’s chapter on the Federal Reserve merits particular attention. In 1992, the author proposed the eponymous Taylor rule, a policy benchmark designed to aid the Federal Reserve in setting interest rates to achieve price stability. Unlike those who want to ‘end the Fed,’ Taylor wants to reform the nation’s central bank. He advocates that the Federal Reserve “focus on long-run price stability within a clear framework of economic stability,” and that it report its strategy and be accountable for deviating from it. Indeed, Taylor suggests that the Federal Reserve’s sole focus should be price stability, rather than its current dual mandate of price stability and maximum employment. He has at least one supporter in Congress. In late 2011, Representative Paul Ryan (R-WI) proposed a similar course of action in a Wall Street Journal op-ed.

In terms of policy, Taylor is largely correct. In my opinion, interventionism has largely not worked in the ways in which its advocates have intended. A commitment to predictability and the rule of law are extremely important for sustaining a democratic polity with a free market system. Where Taylor is less correct, however, is in his analysis of American economic history. Although the United States was partially founded on the principle of limited government, the nation at the time of the founding was largely agrarian and not as committed to economic freedom as we might initially imagine. Fearing the power of finance on our political system, many debated the wisdom of a central bank. Most significantly, slavery, an economic system in which people were considered property, would continue to grow and thrive until the Civil War and Reconstruction. It was not until after the largely industrial North defeated the Confederacy that free market capitalism and a commitment to the rule of law for all people became the country’s dominant economic and political ideologies.

In conclusion, First Principles is a thought-provoking work that deserves a wide audience. Even those readers who will disagree with the author’s analysis will find much to appreciate in this recent contribution to the ongoing debate about America’s economic woes.

Jon Lewis (c) 2012

Tagged with:  

Keynes and Hayek

On October 4, 2011, in economic theory, by Jon Lewis

Keynes Hayek: The Clash That Defined Modern Economics. Nicholas Wapshott. W.W. Norton & Company 2011, pp.382, $28.95 With high rates of unemployment and even higher rates of underemployment plaguing the United States, there are many calls for President Obama and the Congress to do something to alleviate the situation. Although President Obama has not made [...]

Keynes Hayek: The Clash That Defined Modern Economics. Nicholas Wapshott. W.W. Norton & Company 2011, pp.382, $28.95

With high rates of unemployment and even higher rates of underemployment plaguing the United States, there are many calls for President Obama and the Congress to do something to alleviate the situation. Although President Obama has not made much headway in promoting his jobs bill, there is an emerging bipartisan consensus in Washington that reducing corporate income taxes could induce much-needed economic growth. Underlying the debates between liberals and conservatives is a philosophical disagreement as to how much, and indeed whether, the federal government should intervene to counter unemployment and to foster job creation.

Ideas are shaped by historical context. They can also take on a life of their own, freed from those who formulated them, and subsequently impact the course of history in surprising ways. Such is one of the premises underpinning Nicholas Wapshott’s ambitious new study of the parallel lives of and debates between John Maynard Keynes, who advocated government intervention in the economy, and F.A. Hayek, best known for championing the free market. Keynes, who was British, and Hayek, who was from Vienna and is associated with the laissez-faire Austrian School of economics, were two of the twentieth-century’s preeminent political economists. While Keynes was more concerned with the perils of mass unemployment and advocated government spending to counter recessions, Hayek was primarily concerned with what he perceived to be the deleterious effects that inflation had on a society and cautioned against governments intervening in the free market.

In Keynes Hayek, Wapshott, a journalist formerly affiliated with London Times and the New York Sun (full disclosure: I wrote a couple of opinion columns for, and received compensation from, the latter newspaper several years ago), defines his recent work as an attempt to answer the question of who was right, Keynes or Hayek, and to demonstrate that the academic disagreements between the two men continue to define the liberal-conservative political divide to this very day.

The author traces both the intellectual and personal dispute between the eponymous economic giants. We learn that both men’s ideas were shaped by the mass inflation that engulfed the vanquished powers of Central Europe after the First World War. Hayek, whose family personally experienced mass inflation in interwar Vienna, developed a strong bias against governments adopting inflationary measures to fix an allegedly broken economy.

Whereas Keynes argued that government should act in order to improve people’s lives, Hayek believed in the futility of government intervention. Wapshott contrasts the optimist Keynes with the pessimist Hayek, who we are told suffered from clinical depression. “Keynes believed that man had been placed in charge of his own destiny, while Hayek, with some reluctance, believed that man was destined to live by the natural laws of economics as he was obliged to live by all other natural laws.” If one accepts Wapshott’s characterization of Hayek’s pessimism, this begs the question of whether one can be an optimistic Hayekian, believing in the limitation of man to create his own destiny and yet believing that the future is necessarily going to be better than the past.

The author’s greatest contribution to furthering our understanding of the Keynes-Hayek dispute is his discussion of how most presidents, even Republicans who employed Hayekian rhetoric, have implemented Keynesian measures. “For many Keynesians,” writes Wapshott, “Reaganomics was little more than a thimblerig, a political gimmick that, behind the macho Hayekian rhetoric about slashing the size of government, set off a public spending spree on defense that boosted aggregate demand and economic growth.” George W. Bush, after the 9/11 attacks, acted as if he were working right out of the Keynesian playbook with “massive federal spending” which included, among other things, “pork barrel projects, such as the building of fire stations in Maine, that had nothing to do with keeping America safe.” This massive spending splurge would, of course, be criticized by the Tea Party who argued that Bush’s and the Congressional Republicans’ irresponsible spending led to the sovereign debt crisis with which the United States must now contend.

Although rich in detail, highly informative, and generally well written, Keynes Hayek suffers from two notable weaknesses. First, the author could have done more to define and to explain some of the economic and financial concepts that he discusses throughout the book. A lay reader without a background in economics or monetary policy could easily find the earlier chapters rough going. While the work has a selected bibliography at the end, it would have benefited from a glossary that would have made it easier for those with only a rudimentary knowledge of economics to better appreciate the nuances of the debate between Keynes and Hayek. The other major weakness in the work pertains to Wapshott’s seemingly capricious utilization of descriptive terminology. Alan Greenspan is an “ultra-conservative”; the Cato Institute is “conservative”; and Hayek was “never a conservative, but had become a libertarian, but he did not propose a state of anarchy.” Adam Wolfson is at first referred to as a “neoconservative thinker”; just several pages later, he is a “conservative political scientist.” Whether these are accurate descriptions are up to the reader to decide.

So, when all is said and done, who has won the debate: Keynes or Hayek? Wapshott leans toward Keynes, referring to Milton Friedman. “Although Keynesianism has been declared dead a number of times since the mid-1970s, Friedman’s acknowledgment in 1966 that ‘in one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian; is a more accurate, if teasingly ambiguous, assessment of the state of economics in the early twenty-first century.” Yet, at the same time, Wapshott acknowledges that the Tea Party’s adoption of the Hayekian message advocating for small government has made American politics increasingly Hayekian. The battle, it would seem, rages on. Whether the Tea Party will be a lasting force is American politics remains yet to be determined.

In conclusion, Keynes Hayek is an exploration of how two men and their very distinct ideas about the role of government impacted twentieth-century economics and politics. While a useful addition to modern economic history, this work will be appreciated more by those already familiar with the Keynes-Hayek dispute than those who are coming to the subject for the first time.

Jon Lewis (c) 2011

Tagged with:  

The Limits of Economics

On August 1, 2011, in economic theory, by Jon Lewis

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00. In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the [...]

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00.

In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the crisis a result of a liquidity shock, a herd mentality by investors and speculators overly optimistic about ever rising housing values, or the deregulation of the financial services industry? One’s policy and regulatory recommendations will depend to a large extent on how one views the causes of the crisis. If the crisis was the inevitable result of deregulation, more and better regulation is the logical response. If government intervention, however, prolonged and worsened the crisis, then the rational response is for the federal government to do less when the next, similar crisis comes around.

But what if, instead, economists have been thinking about the financial crisis from the wrong perspective? Indeed, what if the very assumptions underlying contemporary macroeconomics have made it difficult to properly understand what went wrong? In Beyond Mechanical Markets, Roman Frydman (New York University) and Michael D. Goldberg (University of New Hampshire) make the case that “the conceptual framework underpinning the debate triggered by the global financial crisis is grossly inadequate for understanding what went wrong with our economies and what should be done to reform them. The reason is simple: contemporary macroeconomic and finance theory attempts to account for risk and swings in asset prices with models that suppose nonroutine change is irrelevant, as if nothing genuinely new can ever happen.”

Frydman and Goldberg argue that, “by ruling out novelty, contemporary macroeconomic and finance models assume away financial markets’ raison d’être—namely, to help allocate society’s capital in the face of nonroutine change and the imperfect knowledge that it engenders in modern economics.” The authors want to place the concept of imperfect knowledge back at the conceptual foundation of macroeconomics. Indeed, they write approvingly of not only John Maynard Keynes and Frank Knight, but also of Friedrich A. Hayek for understanding the limits of knowledge and predetermination when it comes to market prices and risk. The authors, in their Acknowledgements, maintain that they “have likewise been stimulated and sustained over the years by George Soros’s ideas about the role of imperfect knowledge and reflexivity in the workings of financial markets and historical change.” It should be noted that earlier this year Soros wrote an op-ed in which he praised Hayek for the Nobel Prize winner’s belief that imperfect knowledge leads to unintended consequences.

With the premise that economic knowledge is imperfect, the authors propose a different macroeconomic framework – Imperfect Knowledge Economics (IKE). In their view, IKE both incorporates the notion of imperfect knowledge and rejects the notion that knowledge of the (economic and market) future can be fully captured and predicted by rigid mechanistic rules. Their approach should be contrasted with variations of the widely accepted Rational Expectations Hypothesis (REH) framework. Frydman and Goldberg contend that “[r]egardless of their informational assumptions, Rational Expectations models assume away the importance of nonroutine change and the imperfect knowledge that it engenders.”

Given the authors’ emphasis on imperfect information and nonroutine change, it is not surprising that their policy prescriptions would be somewhat different from that of other economists. While they are very critical of the Soviet experiment in central planning and make the case that “the ultimate reason that central planning was impossible is that it supposed that a group of individuals – the planners – could predict and shape the future,” Frydman and Goldberg do not accept a purely laissez-faire approach to the economy either.

Their primary concern is with excessive upswings in asset prices that are followed by prolonged downturns and provide an alternative approach for state intervention. “Because price swings are inherent to how markets help society search for worthy investments, IKE-inspired policy reform suggests that so long as swings in broader market indexes or in key sectors remain within a guidance range of reasonable values, the state should limit its involvement to setting and enforcing the basic institutional framework for market transactions.” They propose that central banks could announce a range of non-excessive values in certain markets as “[a] first step in dampening excessive asset-prince swings.”

Frydman and Goldberg’s contention is that “[t]he need for state intervention in key asset markets arises not because policy officials have superior knowledge about asset values, but because the profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in these markets.” This certainly merits further consideration. They are certainly correct that policy makers do not have, in their words, “superior knowledge.” Indeed, the assumption that a centralized government agency can have such knowledge belies the conceit of central planning that they criticize earlier in their book. With regard to their view that market participants do not internalize the social costs associated with upswings and downswings, one must question whether it is the appropriate role of the state to protect the wider public from these costs.

While on the one hand, the bidding up of stock prices and the subsequent downswing in a market will have a great social cost to the American public (i.e., the unemployment that followed the dot-com boom and bust), the question of how far (and for some readers, if) the state should go to protect the public from market participants is not easily answered. That said, those concerned that Frydman and Goldberg are merely seeking excessively intrusive state intervention into the financial markets would be heartened to know that their “policy measures based on Imperfect Knowledge Economics are not designed to prevent excessive price swings in key asset markets but to reduce their frequency and dampen their magnitude.”

Although Beyond Mechanical Markets is not an easily accessible work for the non-specialist, the authors utilize a clear writing style. This makes it possible for readers to better understand the complex philosophical notions about the role of (imperfect) knowledge underlying contemporary macroeconomic thought. For policy makers and those concerned with the recent dismal news about lagging growth, Frydman and Goldberg’s approach provides a different way of thinking about not only asset prices and markets, but the role of the state in the economy. Even if one does not necessarily subscribe to the authors’ thesis or their policy recommendations, their argument should remind us that there is a different way to look at markets than from the prevailing REH approach.

In conclusion, Beyond Mechanical Markets is a thought-provoking philosophical critique of much of contemporary macroeconomic thought. Those readers interested not only in economics, but also in the history of economic thought will find much of interest in the work.

Jon Lewis (c) 2011

Tagged with:  
iblogpro theme