OVERSTIMULATED

Part Three:
LET IT BE

"There is still a tendency to regard any existing government intervention as desirable, to attribute all evils to the market, and evaluate new proposals for government controls in their ideal form... the proponents of limited government and free enterprise are still on the defensive."

Milton Friedman

David Henderson is a senior fellow at the Hoover Institute at Stanford and a professor of economics at the Naval Postgraduate School in Monterey. The New York Times recently asked Henderson (a friend of this blog) for his reaction to President Bush's proposed fiscal stimulus program. His response: "the economy is working these things out... We’ve got the housing crisis and the subprime, and all these things take a while to settle. The government just doesn’t have the discipline to kind of let things work out."

Henderson is speaking words of wisdom, implicitly referring to general equilibrium theory, a neoclassical extension of Adam Smith's invisible hand, and just one small slice of several centuries of scholarship supporting a laissez faire approach in matters of economic policy. In short, it's a "bottom-up" explanation of macroeconomics, as opposed to the "top-down" approach of Keynes and others. The economy as a whole is merely an aggregate of interrelated smaller markets, composed of millions of individuals. Applying it to our current crisis du jour, a downturn in the housing industry affects the market for loanable funds, causing a shortage in available and affordable credit, which, in turn, affects millions of consumers.

There is something terribly disconcerting about the idea that an industry or market in which you have little participation can wreak havoc upon your personal finances. But there's also something strangely comforting about general equilibrium theory, which also says that markets are self-correcting, that, as Henderson noted, "things work out" in the long run. Prices may rise or fall, supply and demand may shift unpredictably, but ultimately society adjusts, and the markets return to equilibrium.

History provides us with countless examples of this phenomena. The railroad industry in the late 19th Century became inflated, bulging with over speculation and government subsidized corruption. Nearly every railway went bankrupt (with the notable exception of John J. Hill's Great Northern), and investors lost their figurative shirts. But, in time, the market purged itself of dead weight and eventually emerged in a more lean, more efficient form.

A more recent example is the dotcom burst of the late 1990s. Blinded by the novelty of this exciting new technology, investors became willing to ignore warning signs and throw capital at ventures which, in hindsight, were obviously doomed to fail. But the market again eliminated the inefficiencies, and in the long run internet commerce has recovered and continued chugging along-- without any major government intervention or assistance.

The housing market, unanimously pegged as the culprit for our current economic woes, holds many striking parallels. Like the railroads and dotcoms, real estate prices rose partly out of faddism. The market became artificially inflated, and it was only a matter or time before the bubble burst. Although this may seem counterintuitive, the housing crisis and credit squeeze may be a good thing. Those suffering the most as a result of the housing crisis are also those who benefited the most from the circumstances which caused it. We are currently losing wealth that we probably shouldn't have gained in the first place. Simply put, the market is correcting itself.

But that takes time. Henderson, and centuries worth of economic theorists before him, plead with us to simply have patience, withstand the short run difficulties, and allow the market to find its way back to equilibrium, find it's way to efficiency.

While this may be very good advice, it almost certainly will not be adopted. It is not "politically viable." Politicians, and even some economists, stubbornly believe that there exists a way to twiddle and tweak the economy to produce optimal performance. We hold an unwarranted belief in our ability to master the endless mystery and complexity of macroeconomics. Government, bowing to majoritarian whims, interferes with market processes and ignores the unintended consequences of their actions. Albert Venn Dicey, a 19th Century legal scholar to whom few would favorably compare, put it quite succinctly:

"The beneficial effect of State intervention, especially legislation, are direct, immediate, and so to speak, visible, whilst its evil effects are gradual, indirect, and lie out of sight. Few are those who remember that State officials may be corrupt, incompetent, careless, or susceptible to special interests... Few are those who realize that State help kills self-help."