View From Down Under

When I defend the various economic stimulus programs used to fight the latest recession, the typical response from my right wing friends is that government is not the answer to our problems.  The private sector is always better at producing cost effective outcomes, and the less government interference there is, the better.

This is the common understanding of supply side economics.  Lower taxes and less regulation equals higher output, higher government revenue, and better living for all.*

But are the two incompatible?  Does a belief in supply side mean you have to believe the stimulus packages actually made things worse?

The data on economic stimulus is quite clear.  Most economists agree that the US stimulus package has kept the recession from being much worse than it was  – the only argument is by how much.

Recessions are often associated (at their front end) with financial crises and flight from risk.  During good times, investors typically take more risks than they understand (chasing last year’s gains).  They buy equity in highly leveraged businesses which themselves own risky assets (CMOs, Russian bonds, dotcom startups), and often use margin loans to do it.  When things start to unwind, investors flee risky assets.  The resulting collapse in asset values creates uncertainty among both businesses and consumers, who pull back on their own spending and investment plans.  As a result, GDP contracts and recession ensues.

The appropriate government response is to buy risky assets to provide liquidity to the system and prevent financial meltdown (TARP), and to stimulate demand through a combination of lower interest rates and direct government spending  (stimulus).  The 1930s taught us what happens when you do something else.  The fact that the first part of these programs was agreed by President Bush, Barack Obama, and John McCain testifies to the logic.

Only the government is in a position to provide liquidity and stimulus in times of recession.  Not only is it appropriate for the government to do so, it is imperative.

This does not mean government is the answer to everything, or that government should try to ‘micro-manage’ demand over the cycles.  As Bob McTeer, former President of the Federal Reserve Bank of Dallas, writes:  “I don’t get why we can’t be supply-siders in normal times and yet accept that Keynes is relevant for depressions and deep recessions.  Both supply and demand are important.  Why must each side ridicule the other?”

The data I’ve seen supports this view.  In general, less government intervention is better (in economic terms), but there are times when government intervention is appropriate.  I believe government intervention is appropriate where externalities are not properly priced (pollution control); where free riders thwart effective outcomes – otherwise known as ‘public goods’ (fire fighting, street lights, health care); and when economic cycles turn down.  In other (much more eloquent) words:  to establish justice, insure domestic tranquillity, and promote the general welfare.

*This is not actually my understanding of supply side economics.  My understanding of the Laffer curve is that lower taxes only equals higher government revenue if marginal tax rates are greater than t*.  The reduced income tax receipts after the Bush tax cuts suggest the US is somewhere below t*.

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