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January 23, 2012

The Moral Hazard Effects of Current Economic Policy

Robert Samuelson explains how economic policies aimed at smoothing out the business cycle make the economy less stable in the long run:

Since the 1960s, the thrust of economic policy-making has been to smooth business cycles. Democracies crave prolonged prosperity, and economists have posed as technocrats with the tools to cure the boom-and-bust cycles of pre-World War II capitalism. It turns out that they exaggerated what they knew and could do.

There's a paradox to economic policy. The more it succeeds at prolonging short-term prosperity, the more it inspires long-run destabilizing behavior by businesses, banks, consumers, investors and government. If they think basic stability is assured, they will assume greater risks -- loosen credit standards, borrow more, engage in more speculation, relax wage and price behavior -- that ultimately make the economy less stable.

...The Fed slept mainly because ...It didn't recognize that its success at sustaining prosperity -- for which Greenspan was lionized -- might sow the seeds of a larger failure. It bought into an overblown notion of economic "progress."

...The Great Moderation begat the Great Recession. One implication is that an economy less stable in the short run becomes more stable in the long run by reminding everyone of risk and uncertainty.

I like to call this The Clue Bat Effect. Human beings are prone to optimism bias: the innate tendency to underestimate the likelihood of negative outcomes and wildly overestimate the chances of positive ones. The only real antidote to overoptimism is the giant clue bat of reality. Without constant reminders that things can - and do - go tragically wrong from time to time, there is nothing to counter our natural tendency to hope for the best and avoid preparing for the worst.

As this stunning graph suggests, government efforts to "smooth out" inevitable swings in the business cycle have not produced the intended results:

This sobering graph illustrates the folly of centralized planning that interferes with - or even outlaws - signals sent by the market to suppliers and consumers of goods and services. These signals (prices, profits/losses, etc.) may be artificially suppressed for a time, but they are effects rather than causes. And ignoring effects does nothing to address their root causes:

Early in the book, Sowell presents, as one of many examples, how rent controls in a number of countries during the post-World War II period resulted in reducing the supply and investment in new residential construction and in discouraging property owners from maintaining or improving their property. He then demonstrates how the abolition of rent controls dramatically increased the supply and quality of available homes.

Additional illustrations provide examples of government controls of other goods and services, almost invariably resulting in misallocation of resources, supply shortages, and a lower standard of living. For example, in the former Soviet Union, the control of output and the allocation of scarce resources by a central planning agency resulted in surpluses of goods left to rot in warehouses and in shortages that lowered the overall standard of living. In the United States and other countries, agricultural products have at times been purchased by the government to take them off the market and send prices higher. While this process may have benefited large agricultural enterprises, crops were often destroyed while pockets of starvation in the country were evident.

Sowell also has an interesting discussion of the role that profits and losses play in the success or failure of an enterprise. Profits and losses in a free market economy send signals to producers, whether they are using scarce resources efficiently or whether the resources should be used elsewhere.

The artificial suppression/distortion of signals and effects while doing nothing to address root causes lies at the heart of our current economic policy. The results, so far, have been disastrous. But more importantly, they illustrate the fundamentally dishonest basis for our current economic policies. The idea that people will make better decisions if government distorts or suppresses (excuse me, "protects us from") the very information we need to make smart, timely economic decisions deserves to be mercilessly mocked within an inch of its pathetic life.

On a completely unrelated note, thanks to Vanderleun at American Digest and David Foster at ChicagoBoyz for linking over the weekend. Lots of good reading at both sites. But then you knew that :)

Posted by Cassandra at January 23, 2012 06:13 AM

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Cassandra as Tinker Bell.


Eric Hines

Posted by: E Hines at January 23, 2012 09:40 AM

An economic system without failure is like one of those people with the weird and very dangerous medical condition that prevents their feeling physical pain.

Posted by: Texan99 at January 23, 2012 10:57 AM

Tex, that is a keeper. You might want to file for a copyright on it.

Posted by: bthun at January 23, 2012 12:33 PM

An economic system without failure is like one of those people with the weird and very dangerous medical condition that prevents their feeling physical pain.

Hanson's Disease, aka Leprosy.

But as for Cass's point, I liken it to the effect conservation policies have caused forest fires to become much more dangerous and destructive. By preventing as many fires as we can (forest fires being a natural phenomenon which is actually good for the health of the ecosystem), we cause the undergrowth to get to dangerous levels which causes the (inevitable) fire to be worse and more destructive than allowing natural fires to take their course in the first place.

Posted by: MikeD at January 24, 2012 10:01 AM

Somewhat along the lines of Tex99's comment, I refer to the "penny in the fusebox" approach. Back before circuit breakers became common, idiots would sometimes deal with a blown fuse by putting a penny in the fusebox. This would turn the lights back on or the toaster toasting, but also might well burn the house down!

Actually, a power grid includes a whole hierarchy of circuit-protection devices, ranging from the home fuse or switchboard panel up to the giant circuit breakers on long-distance transmission lines, all of them intended to isolate failing parts of the system while letting the other parts continue to operate. In the political case, it seems that the "progressive" approach is to defeat or disconnect the protection devices at all levels.

Posted by: david foster at January 24, 2012 06:28 PM

A prolonged period of economic fail makes it more likely that something good will happen......

The abject failure of the system and loss of hope eventually promotes dejected individuals to take their future as their own responsibility....

If only.

(Sheesh - I'm embarrassed to be showing up two weeks late)

Posted by: tomg51 at January 26, 2012 03:32 PM