Why Be Optimistic about the Future?

by Gary Wolfram

The U.S. economy is on the mend and has been for some time. The reason is that, as Marx acknowledged in The Communist Manifesto, the capitalist system is an engine of powerful forces.

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Market capitalism, true capitalism and not big government colluding with big business to engage in what Bastiat called “legalized plunder,” is the most efficient way of organizing resources. As a system it drives innovation, which is the source of our increased standard of living. In fact, this system is so powerful and efficient that our economy is doing well in terms of producing goods and services, not because of government intervention, but in spite of it. There is no question that the federal government has been engaged in activities that have suppressed and will continue to suppress economic growth and will leave millions of our person unemployed for lengthy periods. But the economy as a whole will be productive and our gross domestic product will continue to increase in the near future.

There is substantial empirical evidence that the economy is recovering. Fourth quarter real GDP grew at a 5.6% annual rate, the Federal Reserve Industrial Production Index was up in March for the 9th month in a row, the ISM manufacturing index was up in March to 59.6 and the employment index was at 55.1, the fourth straight month above 50, housing starts and existing home sales were up in March, the Conference Board’s Index of Leading Indicators increased 1.4% in March, and one can cite more data showing the upside of the business cycle is underway.

At issue is why is the economy recovering and is it likely to be a sustained recovery? We may also ask why unemployment remains stubbornly high while production is increasing. Normally, as the economy comes out of a recession productivity increases, part-time employment increases, and finally full-time employment increases. Why have we yet to see the last stage of this process?

The Obama administration believes that the recession is best relieved by attempts by the federal government to increase aggregate demand. This is a classic Keynesian prescription for economic downturns. Underlying this belief is the assumption that the market economy is inherently unstable, and that the economy can come to equilibrium at a point where the demand for all goods and services equals the supply of all goods services and yet the labor market is at less than full employment. The “stimulus package” fits the Keynesian theory nicely—increase federal spending and reduce tax rates on those who would spend more in order to offset the lack of demand in the economy.

The problem is that the recession is not due to a lack of aggregate demand, whatever that may actually be, but due to what Friedrich Hayek, winner of the 1974 Nobel Prize in economics, called malinvestment. Hayek subscribed to what is now called Austrian business cycle theory. This theory is that business cycles are caused by credit injections by the central bank which artificially lower interest rates. This lowered interest rate distorts the price signal for producers as to the willingness of consumers to forgo consumption today in return for goods in the future. Producers then engage in production of capital goods, such as housing, for which the demand is not sustainable. The upside of the business cycle results in overemployment in certain industries. When the credit expansion ceases, or in some cases, merely slows down, the reality of demand and supply becomes apparent. In order for labor and other resources to move to industries where the demand is sufficient to sustain employment, labor and resources must become temporarily unemployed. This is the downturn of the business cycle.

In his Nobel address, “The Pretence of Knowledge,” Hayek explained that once the central bank has set in motion the excess liquidity that distorts the price signal for savers and investors, there is little to be done other than await the market response that will result in equilibrium in the goods and labor markets. The labor and resources that have been misallocated will eventually find their proper location. Attempts by government to prop up prices and artificially stimulate demand in the sectors with malinvestment will only continue the misallocation and lengthen the time it takes for resources and labor to find those industries where consumer demand is sufficient to employ them.

The recent recession is a textbook case of Austrian business cycle theory. The Federal Reserve lowered the federal funds rate from 6.4% in December of 2000 to 1% by July of 2003 and kept the rate there for one year. Then, fearing inflation might occur, the Fed increased the rate gradually to 5.24% in July of 2006. The lowering of the interest rates created an artificial boom in housing, with the malinvestment of resources that Austrian business cycle predicts. Once the artificial interest rates were lifted, it became clear that the demand for housing was not sufficient to maintain absorb the amount of housing that had been built and sustain the employment of resources in the housing industry. Housing prices collapsed and the distortion of resources was felt throughout the economy.

A problem with ability of the market system to repair itself and create wealth for the masses is that government action which slows the recovery will be held up as having been the cause of the recovery. In the past I have suggested this is akin to the story of the man who is sitting on a park bench and every two minutes jumps up and waves his newspaper in the air. A second man, observing this for awhile, walks up and asks what the first man is doing. The first man says, “I’m scaring away the elephants.” “There are no elephants around here,” protests the second man. The first man responds, “See. It works.”

This is what is happening as our federal government engages in stimulus packages, health care reform, regulatory reform, and every other reform of which it can think. Each action actually slows down and hampers the recovery, but the economy still makes steady progress repairing itself and thus the federal action is held up as if it were the cause of the recovery.

Robert Higgs, in a 1997 paper and a book published in 2006 argued persuasively that the Great Depression was in large part due to what he termed “regime uncertainty.” The uncertainties caused by the various interventions and programs of the Roosevelt administration created a situation where private investors were afraid to invest. Higgs provides evidence of polling where a substantial number of corporate executives thought it possible that all of the economic system would be socialized.

I would argue that the failure of part time employment to be converted into full time employment in this recovery is due in large amount to the same regime uncertainty that Higgs discovered in the Roosevelt administration. The Bush administration had no explicit theory about how it would solve the financial crisis. Bear Sterns was rescued, Lehman Brothers is left to bankruptcy, Fannie Mae and Freddie Mac are taken over, AIG is bailed out. The TARP bill was originally to buy toxic assets from banks, then was used to inject capital into the banks, then it was decided that it could be used to provide loans to auto companies.

The Obama administration accelerated the pace of uncertainty with its 1000 page stimulus bill, the 2300 page health care legislation, the cap and trade tax proposal, massive financial regulatory legislation, cash for clunkers program, and first time home buyers tax credits which expire and then are reinstated. Employers don’t know what the cost of hiring a new worker will be, whether they will get a tax credit for hiring if they wait, what kind of health care benefits they will be mandated to provide, whether their customers will receive a credit for purchasing their product if they wait a month, or whether their lender will face new regulations in providing them credit. We should not be wondering why unemployment is so high, but rather why it is so low given government intervention.

Why be optimistic about the economy when the federal government has created such uncertainty, has immersed itself into the health care industry, and is about to attempt to micromanage the financial industry? For two reasons. First, as noted above, the market capitalist system is extraordinarily resilient. There are massive incentives to figure out how to make the best of a bad situation. Second, it appears that people have been awakened to the massive government intervention that is a drag on the economy. This may well result in the restoration of rule of law, individual liberty and responsibility, and limited government, which are essential to a market economy. This will require effort on the part of those dedicated to liberty and the creation of wealth for the masses through the institution of market capitalism, but the time is ripe for restoration of a free society in America and the expanding economy that will result.


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Posted May 1st 2010 at 5:29 pm in Uncategorized | 131 Comments