The Ghost of Economics Past

What would the world's economics Nobel Prize laureates make of Barack Obama's response to the financial crisis?

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By all accounts, President Barack Obama and his party may be in big trouble. The Nov. 2 U.S. congressional elections, judging by the latest polls, are shaping up to be a pointed response to the Democrats’ stewardship of the economy. More precisely, they are a referendum on Obama and his predecessor’s big economic bets, grounded in 70-odd years of economic theory: the bailout of the financial system and auto companies, the economic stimulus package, regulations reining in Wall Street, and George W. Bush’s tax cuts for the wealthiest Americans.

With Goldman Sachs predicting that the economy is going to be “fairly bad” or “very bad” over the next few months, Obama could probably use a little smart advice. So now that Peter Diamond, Dale Mortensen, and Christopher Pissarides have been named the winners of the 42nd Nobel Prize in economics, let’s take a look at what previous Nobel laureates have contributed to our understanding of the current economic crisis — and what they might have made of the solutions that have been attempted or proposed so far.

One question arising out of the recent economic turmoil is whether the bailout of the country’s largest banks and automobile manufacturers was prudent. From one side of the debate, we hear that the bailouts were an unnecessary expansion of government into the private sector. No doubt Friedrich Hayek (1974 Nobel laureate) would agree and warn us that bailouts violate the principle of private enterprise, threatening to put the country on a dangerous path toward socialism. The Tea Party would have found a kindred spirit in Hayek — and indeed, its more erudite members refer to him often.

James Buchanan (1986) offers a less philosophical case against the bailouts. The government, he would argue, is populated by self-interested bureaucrats who always put themselves first — how can such self-promoting officials objectively choose which banks to bail out and which to abandon? Will they base their decisions on the public good or on their own private interest?

On the other hand, Paul Samuelson (1970) would likely have pointed out the similarities between the current situation and the banking crisis of 1933, when the government had to shore up the financial system long enough to allow the private sector time to recover. Letting one bank fail may make sense on a microeconomic level but letting many large banks fail can be catastrophic on a macroeconomic level. The failure of one large bank can bring down another in a cascading effect that can create chaos in the financial sector.

Even a successful bailout, however, may create problems in the long run if banks start to believe that the government will bail them out in the future. As a consequence, these banks may be more likely to make risky investments, a concept described by Kenneth Arrow (1972) and Joseph Stiglitz (2001) as moral hazard.

What about the stimulus package, with its massive increases in government spending? Did that provide a boost to the U.S. economy? Economic models by Edward Prescott and Finn Kydland (2004) would probably show no benefit at all. The real business cycle model they developed generally doesn’t respond positively to government deficits in the short run or the long run. However, a model by Lawrence Klein (1980) would have shown a positive benefit because his equations were derived from the theories of the influential macroeconomic theorist John Maynard Keynes. In a Keynesian model, government deficit spending energizes a depressed economy and can stimulate investment and consumption in the private sector.

What about the tax cuts in the stimulus package — were those beneficial? James Tobin (1981) was a member of the Council of Economic Advisers in the 1960s that convinced President John F. Kennedy to cut $11 billion in personal and corporate taxes to combat a small recession. The stimulus worked, and became an essential component of Keynesian policies, inspiring the stimulus package of 2009. During the current crisis, Paul Krugman (2008) has endorsed spending increases and tax cuts, but argues that the actions contained in the stimulus package were insufficient given the severity of the crisis.

Using fiscal policies like these to fine-tune the economy has always been controversial. By the theories of Edmund Phelps (2006) and Milton Friedman (1976), they’re at best irrelevant — the unemployment rate is fixed in the long run, Phelps and Friedman argue, and no amount of government spending or tax cuts can change that fact. Even if a stimulus package temporarily reduced unemployment, in this theory, it would be entirely ineffective over the long haul.

Tobin’s thinking on tax cuts was less black and white. Although he favored the measure in the Kennedy years, he had nothing good to say about the Reagan tax cuts, which he thought did little more than “redistribute wealth and power to the wealthy and powerful.” It is unlikely that he would have supported extending the Bush tax cuts — which the Democrat-led U.S. Congress seems poised to do today — for an upper class that has become arguably wealthier and more powerful than it was in the 1960s. You would expect to find Robert Mundell (1999), a prominent proponent of supply-side economics in the 1980s, on the opposite side of the argument: According to Mundell, tax cuts for the rich provided an incentive for them to invest more and work harder, thus benefiting the entire economy.

Then there’s the Federal Reserve, which has played a major role in combating the economic crisis by injecting large sums of money and liquidity into the U.S. economy. Franco Modigliani (1985) was one of the first Keynesians to endorse an expansionary monetary policy like this under conditions of high unemployment. The strategy seemed to work, long enough that it eventually became a standard tool for the Federal Reserve, one the bank deployed in 2008.

But Friedman would likely have objected strongly to any attempt by the Fed to increase the money supply in the name of fighting a recession. The result of such a misguided strategy, according to his monetarist theory, would be inflation, not economic recovery. (There is one notion here, however, on which most economists might agree: the Fed’s role as the lender of last resort. When panic strikes financial markets, aggravated by temporary shortages, the central bank has a unique opportunity to provide liquidity — this was, after all, one of its original purposes.)

Confused yet? It should be clear by now that if you seek clear, unambiguous policy guidance, the Nobel laureate roster is probably a bad place to look — economic theory, even when honored with the top prize in the field, is brutally contested terrain. Unlike physics, chemistry, physiology and medicine, the Nobel Prize in economics seldom delivers a vetted and verified discovery, but rather highlights novel and interesting ideas. At their best, however, Nobel-winning economic theories can inspire policies that protect the environment, reduce poverty and unemployment, subdue inflation, ensure prosperity, and of course, avoid economic depression. Let’s hope for the best.

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