Government and Macroeconomic Uncertainty

Economics is probably both the most over-rated and the most under-rated science at the same time. It is under-rated because when done right, it holds the answers to how we can eradicate poverty, protect liberty and build prosperity. 

On the other hand, when done wrong economics quickly becomes a vastly over-rated science. Economists have a penchant - verging on mass hypnosis - for getting lost in seemingly sophisticated mathematical analyses. Mainstream economics journals today are inundated with "rigorous" problems and narrow applications of carefully selected deductive methods. Mathematics classes are not only mandatory, but revered among economics graduate students and the faculty teaching them. 

Yet the applicability of their technically slanted methodology is inversely related to its mathematical sophistication. The more complex the mathematical reasoning becomes, the narrower the problem they can define.
Logically, this also means that the higher the technical skills are of young economists today, the less useful they are in addressing real social and economic problems. There are, in fact, economists who spend their entire academic career studying the fascinating problem of how one consumer relates to one product. 

While such introvert research does not dominate economics today, the fact that it exists and thrives on the margin speaks volumes to how irrelevant economists have made their profession. Over the past half century the United States, Canada and almost all of Europe, have gone from annual growth rates in excess of four percent to a slow but inevitable drift into economic stagnation. The American economy, one of the strongest in the world today, is not even growing at three percent. Yet economists allocate almost no resources into researching this problem. 

One reason for this is that the problem does not lend itself to a neat equation system, or for that matter some econometric data crunching. The problem is far more complex and - in the genuine methodological sense of the term - open-ended. You cannot get a neat mathematical conclusion, or obtain statistical significance, in a system where interacting variables do not easily, or at all, lend themselves to quantitative analysis. 

Since economists to a large degree prefer to put the carriage before the horse and let methodology dictate what problems they study, the question of the world's slow but seemingly inevitable drift toward economic stagnation has been left unanswered. 

But it is not just the obsession with rigorous techniques that bar economists from addressing this problem. Mainstream economics as well as Austrian theory rely on premises prescribing that if the free market is left alone, it will produce a maximum of prosperity for all of us. With this "conclusion" as an axiomatic guideline, most economists will steer clear of the global stagnation problem and dismiss it as easily solved by minor tweaks to the role of government in the economy.

The problem with the world, and our modern industrialized society, is that it does not have a built-in growth engine. Yes, the free market is by far the best pathway to the best possible scenario of growth and prosperity for all, but it is by no means a safe bet that just because we leave the market alone, it will solve all our problems. In fact, even an economy with a minimal state (in the true libertarian sense of the term) can get stuck in a deep depression. 

The reason is called "macroeconomic uncertainty". It is a rare phenomenon, but it does exist. The first encounter with it in modern times was the Great Depression in the early 1930s. All economic agents, from investors to entrepreneurs to consumers, went into "lockdown", fearing that whatever money they spent would prove to be wasted, and besides, what if some even bigger economic disaster would happen in the near future? 

When a solid majority of economic agents think the same way and therefore go into economic lockdown, the decision is perfectly rational at the individual level but the macroeconomic outcome is nothing short of a disaster. Yet as milder versions of the Great Depression have shown - the deep recession in Denmark in the 1980s, the Swedish meltdown in the early '90s, the Great Recession to mention a few - the combination of individual rationality and collective irrationality does exist. 

The question for libertarians to ask, then, is whether to accept the fact that a free-market economy can get stuck in depressions, or to find some way to mitigate, even counter, those rare but very destructive eruptions of macroeconomic destruction. 

Keynes, the first economist to systematically address the phenomenon of macroeconomic uncertainty, never got very far beyond defining and analyzing the nature of the problem itself. This, however, was a monumental accomplishment in itself, and even if Keynes had not suffered a heart attack soon after publishing General Theory, it is by no means certain that he would have taken on the next part of the problem:

What can government do to solve the problem of macroeconomic uncertainty?

To answer this question we need to first understand something about the microeconomics behind the "lockdown" described earlier. Again: when the going gets uncertain it is perfectly rational for us all to decide, at the individual level, to refrain from spending, to hold on to our cash and to pray for a better tomorrow. 

In our daily lives we take actions to prevent a macroeconomic meltdown. We do it without realizing that this is actually the purpose behind our actions: we enter into contracts with landlords that keep the lease on our apartment constant for months, perhaps years at a time; we prefer a given hourly wage or monthly salary to not knowing from one day to the next how much we will make; our mortgages, car loans, insurance payments are all contracted to keep the cost predictable, often for 6-12 months at a time. 

Even prices that are not negotiated tend to stay stable. The gallon of milk we buy two or three of every week costs approximately the same from one month to the next (even where prices are not dictated by idiotic government regulations). A pound of ground beef, a package of spaghetti, a bar soap... they all come at prices that are either constant for a long period of time or vary within predictable margins. 

When prices vary outside a certain range - see gasoline prices - we get irritated. The fact that gas-price variations do not cause more upheaval in price-stable economies is attributable to exactly that: their variations are irritating but not big enough to cause major problems for us in predicting the future. 

Price stability is one way for us as individuals - and for businesses - to create a more predictable economic environment. The quality of the products we buy is another. Availability is a third. Even if we do not sign explicit contracts with people to deliver, say, a a pound of Tillamook extra sharp cheese once a week, the regular availability and predictable price and quality of the product are good reasons for us to become recurring customers. 

This may all seem trivial - after all, if we did not have an everyday life that looked like this, then what would our daily lives look like?

The answer to that question is a direct door opener to macroeconomic uncertainty. It is a state of economic affairs that is the precise opposite to the stable, predictable economy we are used to. 

A state of macroeconomic uncertainty is also a state that the private-sector economy is practically incapable of pulling itself out of. Austrian economists, and other fervent followers of Say's Law, would say that this is untrue, that if you just wait long enough the relative prices of products and labor will fall to a point where entrepreneurs will find it profitable to start producing again. 

To this point, there are two answers. The first is the simple yet challenging answer from a rhetorically amused Keynes: "In the long run we are all dead". Some Say's Law disciples, such as Swedish economics professor Assar Lindbeck, claim that Says' Law takes a century to come full circle; how many people can wait for a century for an economy to pull itself out of a depression under macroeconomic uncertainty?

The second answer is that it does not matter how low wages fall relative product prices. If nobody wants to buy the products, because they won't part with highly valuable cash, then it does not matter how low prices fall (with the exception of a strictly theoretical marginal decline to zero). For this reason it is meaningless - almost in the logical sense - to wait for the free market to pull the economy out from under the blanket of macroeconomic uncertainty.

To put it bluntly: in a depression - but not in a regular recession - government must facilitate enough economic activity to break the vicious circle of uncertainty. Contrary to conventional wisdom, this does not mean spending money on bridges, solar panels or botched experiments with electric cars. It is much more basic than that. Government needs to repair the bridge of confidence between the present and the future, to remove a basic portion of the economic loss that people fear when stuck in a state of macroeconomic uncertainty.

But what policies could do that? What exactly does a stop-loss mechanism mean in a macroeconomic context??

Please be patient. We are almost there.