The limits of government activism: and the role of risk, liquidity, and speculation in a thriving economy.

• Author: Greenspan, Alan

In these extraordinarily turbulent times, it is not surprising that important disagreements have emerged among policymakers and economists on the issue of economic activism. Almost all agree that activist government was necessary in the immediate aftermath of the Lehman bankruptcy. The U.S. Treasury's equity support of banks through the Troubled Asset Relief Program, and the Federal Reserve's support of the commercial paper market and money market mutual funds, for example, were critical in assuaging the freefall. (1) But the utility of government activism, as represented by the 2009 US$814 billion program of fiscal stimulus, housing, and motor vehicle subsidies and innumerable regulatory interventions, continues to be the subject of wide debate.

Regrettably, the evidence is such that policymakers and economists can harbor different, seemingly credible paradigms of the forces that govern modern economies. Those of us who see competitive markets, with rare exceptions, as largely sell-correcting are most leery of government intervening on an ongoing basis. The churning of markets, a key characteristic of "creative destruction," is evidence not of chaos, but of the allocation of a nation's savings to investment in the most productively efficient assets--a necessary condition of rising productivity and standards of living. But human

nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policymakers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.

The problem for policymakers is that there are flaws in both paradigms. For example, a basic premise of competitive markets, especially in finance, is that company management can effectively manage almost any set of complex risks. The recent crisis has cast doubt on this premise. But the presumption that intervention can substitute for market flaws, engendered by the foibles of human nature, is itself highly doubtful. Much intervention turns out to hobble markets rather than enhance them.

LIMITS TO FISCAL STIMULUS

The recent pervasive macro-stimulus programs exhibit the practical shortfalls of massive intervention. They assume that the impact on the U.S. economy of a set of tax cuts and spending programs can be accurately evaluated and calibrated by conventional macro-models. Yet these models failed to anticipate the crisis, and given their structure, probably cannot be so evaluated and calibrated. (2)

How can the internal structure of models that have such poor forecasting records be informative on the size and sign of coefficients and impact multipliers? Moreover, most stimulus programs seek those appropriations and tax cuts most likely to be quickly spent. But if they were all completely spent--presumably the ideal then of necessity saving would be zero. Yet in that case, no production would have been diverted to foster innovations that increase output per hour and standards of living.

The argument that higher federal spending would raise nominal GDP and create new saving is accurate up to a point. But if aversion to illiquidity risk remains high, capital investment and GDP will presumably remain stunted. This raises the broader question of government economic activism as an important economic variable contributing to such heightened risk aversion.

THE BOUNDARIES OF ACTIVISM

I define zero activism or intervention as pure laissez faire, where the government has no economic role other than enforcing property rights and the law of contracts. This paradigm, in its pure form, has never existed. The United States and much of the developed world came close in the first half of the nineteenth century. But in the United States, slavery and state-financed infrastructure, such as the Erie Canal, were departures from the paradigm.

This paradigm eroded during the second half of the nineteenth century, and was abandoned for a heavily regulated economy in the aftermath of the Great Depression. For the second half of the twentieth century, Americans, belatedly dismayed with the restraints of regulation, dismantled most controls on economic activity. Much of the rest of the world followed suit.

Few deny the extraordinary economic growth engendered by competitive markets in the nineteenth and twentieth centuries--a tenfold increase in global real per capita GDP (Maddison 2005). But the distribution of a competitive market's rewards, and its periodic crises, led to the emergence in some countries of virtually full state (activist) control of economic affairs. The Soviet Union, China (during its Cultural Revolution), and India (with its embrace of Fabian socialism following independence in 1947) were the most prominent. Yet these models have been abandoned as ineffective creators of material well-being.

The economic policy world is currently split between the advocacy of a state of minimum activism--allowing markets largely free rein--and the advocacy of a more heavily regulated interventionist model. Both embrace the...