Economics and Politics, Part 2

My views don’t fit neatly into the left-right political spectrum boxes. This is both a gift and a curse. The gift is that I am not blinded by party biases. (I have my own biases, thank you!) The curse is that I observe others, on both sides of the left-right divide, suggest that the other side is littered with extremists. The latest example comes from Mark Thoma, who has a new column at the Fiscal Times that begins:

The upcoming presidential election gives voters a choice between two very different philosophies of government. For Democrats, an activist government is necessary to keep markets functioning, and to smooth economic fluctuations. Without government oversight, markets would be captured by monopoly power, consumers would be at the mercy of unscrupulous producers, there would be distortions from adverse selection, information asymmetries, moral hazard problems, and so on. In addition, if government does not take action when a recession hits, the downturn will be much worse and much longer than necessary.

For Republicans, however, activism is exactly the wrong approach to take. They believe that the key to making markets work and smoothing economic fluctuations is for the government to get out of the way and let the private sector work its magic. In general, markets react faster, incorporate more information, and regulate commercial behavior better than humans will ever be able to do.

There are several problems with these opening paragraphs, some economic and some factual. First, let’s deal with the economics. Thoma suggests that Democrats think that government intervention is necessary to ensure the smooth functioning of markets. I’m not in the business of understanding what Democrats think, so I will take him at his word as this seems a reasonable characterization. So why do Democrats think that government needs to intervene? Because markets suffer from adverse selection, moral hazard, information asymmetries, etc.

What is curious is that Thoma then suggests that in an economic downturn we need government intervention because of these information frictions. Really? I don’t see this as the argument for fiscal stimulus. The arguments that I see are that the government can fill the output gap, so to speak, or that the multiplier from fiscal stimulus is greater than one, or that deficit spending is self-financing (the irony of that last statement being uttered critics of supply-side economics makes my head spin). Regardless, it is not clear why fiscal stimulus follows from information frictions. (Perhaps there is a coordination failure argument here?)

But let’s get back to the information frictions. Do the existence of such informational frictions necessarily imply that we need government intervention? The answer is no. Asymmetric information is everywhere. It’s hard to think of markets where asymmetric information doesn’t play a role. Of course, to leave it at that would be unfair. In some cases the effects of asymmetric information is more important than in others. But let’s consider one of the most obvious cases of imperfect information. Suppose that individuals cannot perfectly and credibly commit to future actions. Two individuals meet to trade. One is a buyer. One is a seller. The buyer wants to give the seller an IOU in exchange for goods — i.e. he wants credit. In the absence of perfect commitment and without access to the trading history of the buyer, no seller will extend credit. This is why we need money. Governments, you might point out, can step in and provide fiat currency. However, the historical emergence of commodity money would seem to suggest that there are non-government solutions. Now, of course, fiat and commodity money have their trade-offs, but it is not obvious that fiat money is preferable — although it has the potential to be.

In addition, government policies can actually create information frictions and moral hazard. Thus, the existence of information frictions is not prima facia evidence that government intervention is necessary. Thoma admits this, but then goes back into attack mode:

Government isn’t perfect, but neither is the private sector (see the bulldozed waste from the housing bubble), and on net it’s helpful for the government to take action when relatively severe market failures are present. Traditionally, those who take a more hands off approach do not deny that all markets fail to some degree – no market is perfectly competitive. But for the most part they do not see these failures as having large consequences, and even when they do, government intervention is rarely the solution. In many, if not most cases, that just makes things worse.

In the modern Republican Party, these views have been taken to the extreme so that government is rarely, if ever, supported.

I don’t know, it seems to me that the Republican Party quite likes government intervention. It was George W. Bush who bailed out the automakers, ushered in TARP, gave (the always ineffective) tax rebates in early 2008, expanded Medicare, conducted nation building exercises in Iraq and Afganistan, etc.

Thoma continues:

Who will build bridges, provide sewage systems, national defense, roads, airports, water systems, and so on if not the government?

And here we get to the true source of debate. I agree. Let’s build bridges and roads and rebuild some infrastructure. We can finance these at historically low interest rates. But who is proposing doing that? The Democrats? Not likely. Supposedly President Obama wanted more infrastructure type projects in the stimulus package, but it ended up mostly being a transfer payment to the states.

Thoma concludes:

There was a time when extremists were not the main voice of the Republican Party, a time when we had some chance of dealing with important issues.

This is the meme on the left, but I don’t buy it. Mitt Romney is the presidential nominee — a moderate Republican from Massachusetts. Marco Rubio, his likely running mate, was called a “centrist” by the New Yorker (The New Yorker!).

I’m not trying to defend Republicans. However, the theme that I see on the left is that President Obama is an innocent victim of obstructionist Republicans. As an outside observer, I see obstructionism on both sides. The respective parties have drawn their lines in the sand and neither will budge. It’s also not clear to me that if either or both sides did budge, we would get anything akin to optimal policy. (Compromise is sometimes good — see Bill Clinton and the Republicans in his second term. However, it is sometimes bad — see No Child Left Behind.)

Finally, I think that it is misleading to suggest that only fiscal stimulus could have and can solve our economic problems. The view of the discipline prior to the recession was that monetary policy was effective and fiscal policy was irrelevant. I happen to agree with Thoma that infrastructure spending would be a good idea at historically low interest rates. However, my support comes from the view that the marginal benefit of these projects would outweigh the marginal cost. If the economy gets a boost from these projects, all the better. However, to suggest that the slow recovery of the economy is because of the Republican Party is opposed to government intervention is far from obvious and overly partisan — especially from someone who is usually more thoughtful on economic issues.

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