Economists, politicians, and pundits looking for answers to the economic crisis fall into two broad categories. Keynesians and statists argue for more aggressive interventions from governments and central banks. Distrusting the free markets self-regulating processes, they promote public spending to create jobs and low interest rates to rekindle private investment and consumer spending. Thinkers of the classical-liberal persuasion, by contrast, argue that no quick fix can bring the economy out of its doldrums; only when the rules of capitalism appear stable and predictable again will markets revive. Put another way: Keynesians and statists believe in flexible, discretionary economic policies; classical liberals believe in set rules.
Economic history proves the superiority of the second approach, but democracy often makes the first more attractive to politicians. After all, in a crisis, people expect their leaders to do something; refraining from action and sticking to abstract principles play poorly to public opinion. As previous recessions demonstrate, however, public pressure for action usually leads to bad decisions that prolong or intensify a crisis. The situation is analogous to what happens on the soccer field when a goalie faces a penalty kick. Statistics show that the goalie should stay in the center of the net to increase his chances of blocking the shot. Yet in most cases, he jumps to the left or right just before his opponent kicks. Why? Because the crowd urges him to act, even though doing so reduces his likelihood of success.
Since the beginning of the crisis in 2008, governments have similarly lurched from side to side, to little good effect. True, some basic market-supporting rules—those that back free trade and oppose inflation, monopoly, and the nationalization of industry—have been maintained since 2008. This stability compares favorably with government responses to the Great Depression in the 1930s, which made things worse by permitting nationalization and monopolies while interrupting the free flow of goods, capital, and people. In 1974, too, wrongheaded policies magnified a crisis. After oil-producing nations formed a cartel, OPEC, and boosted oil prices dramatically, Western production costs shot up, smothering consumer spending and bringing the economy to a standstill. To reignite growth, Keynesian economists persuaded central banks to print more money than ever before. All Western governments followed this prescription, leading to an explosion of inflation. Because neither consumers nor entrepreneurs would increase their spending or investment in that climate (they rightly assumed that these were short-term, unsustainable policies), the result was disastrous stagflation—economic stagnation and inflation combined.
Governments and economists, who learn by trial and error, fortunately havent repeated the worst mistakes of the 1930s and 1970s. That may explain why the current crisis hasnt become even more serious. Yet public pressure to act remains, and politicians and the media, who have only a shaky understanding of how markets work, continue to promote active government policies, such as the American stimulus bill of 2009. Most countries that went down this road (with some exceptions, including Germany and the Baltic states) have incurred huge deficits, which hamper private investment and job creation. The renewed failure of stimulus efforts confirms that Keynesian policies, in the long run, dont work.
How can governments resist the pressure to adopt short-term policies and instead promote long-term, steady approaches to maintain economic growth? Here are some suggestions. Instead of holding an endless debate on taxes and deficits, classical liberals in the United States could promote a constitutional amendment that imposes a ceiling on total federal spending. Throughout the history of capitalism, the level of public spending has had more impact on GDP growth rates than has the deficit or the marginal tax rate. In America, a public-spending cap would calm the anxieties of entrepreneurs and consumers, make the future more predictable, and provide a strong incentive for businesses to invest the huge quantities of liquid assets now frozen or invested in unproductive bonds. The amendment would restart the innovation cycle that has always been the main driver of American economic expansion.
Long-term rules in the United States could also put an end to the excessive concentration of political and financial power in the hands of a limited number of banks—a problem that helped disrupt the world economy in 2008 and threatens to do so again. As University of Chicago economist and City Journal contributing editor Luigi Zingales shows in his new book A Capitalism for the People, the United States increasingly risks becoming, in economic terms, a banana republic—a place where a few big banks destroy public confidence in the free market and deplete the economys resources through short-term speculation instead of investing. New rules could put a stop to that by limiting the size of banks, which would reestablish competition.
Classical liberals could also push to make the Federal Reserves monetary policy more predictable. As Milton Friedman demonstrated half a century ago, the American economy grows steadily when the Fed injects money and credit into the economy in steady, predictable quantities. When the Fed tries to do more, it usually produces speculative bubbles, inflation, and stagnation. Stanford economist John Taylor, who writes on the importance of rules elsewhere in this issue, has proposed an algorithm for the Fed that would adjust monetary creation to the needs of the economy. The Taylor Rule should become a legal constraint on the Fed, preventing it from adopting discretionary and counterproductive policies.
Europe also needs firm rules, not ever-changing policies—but there, its less urgent to invent new rules than to create the federal institutions that will guarantee the proper implementation of existing ones. If eurozone members had respected the conventions that they had signed limiting public spending and deficits, there would be no European crisis today.
What is to be done to grow out of the economic crisis may be clearer than how to do so in a democracy. Political leaders must build constituencies that will support rules instead of discretionary policies. The best way to do that is to explain how rules reinforce the power of the people. In the United States, a public-spending cap would protect taxpayers from the politicians who bestow subsidies and from the lobbyists who seek them. Rules to jump-start competition in the financial sector would help re-democratize American capitalism, which has become too oligarchic. In Europe, too, transparency in public accounting and new federal institutions to implement euro rules would reinforce popular democratic control over the prodigal ways of the political class.
Since the crisis began, discretionary policies have thrived, and set rules have suffered. To end the crisis, we must reverse that situation, restoring rules to their rightful place in our free-market economies.