Wednesday, September 5, 2012

New IEA Discussion Paper on the Great Recession

"Earlier today the Institue of Economic Affairs released my Discussion Paper "Causes and Cures of the Great Recession." There's not much that's new in there, but I do think it's a handy summary of some of the things I've been writing on this topic over the last few years. The IEA blog has a condensation here. A snippet: The recession and recovery are the economy attempting to shed capital and labour from where it is no longer profitable and then figuring out where it would be better used. This process takes time, which is why recessions have unemployment and slow growth. Boosting aggregate measures of consumption and investment through government stimulus will not help, as the problem lies not in macroeconomic aggregates but in the microeconomic allocation of resources. Only those located in the context of the market have the knowledge and the feedback processes provided by prices and profits to make the decisions that will reallocate resources as quickly and effectively as possible. The decentralised decision-making and learning processes of the free market, and not more of the government intervention that caused the problems, can accomplish the millions of corrections are needed to get resources where they belong and return to a sustainable pattern of high employment and growth." Executive Summary: For many, the Great Recession and the boom that preceded it are evidence of the failure of the supposed deregulation of financial markets in the last decade and therefore constitute an indictment of capitalism more broadly. However, a closer look at both monetary policy and the effects of other government interventions on the financial system tells a very different story. The Great Recession was not a failure of free markets. Rather it was a classic example of the undesirable unintended consequences of government intervention, both through expansionary monetary policy and misguided attempts to bolster the housing market in the USA. This combination produced an unsustainable boom in the years following 9/11, with the focus of that boom being a policy-induced asset bubble in housing and the resulting collection of financial instruments built on that bubble. Because the boom involved the misallocation of resources due to false interest rate signals, it is proper to characterise the boom as the making of the mistakes and the inevitable bust as their correction. The only way to correct that misallocation is to let entrepreneurs guided by market prices, profits and losses figure out where resources now need to go. Government spending programmes are both too blunt and too politicised an instrument to do the job. In the long run, the way to prevent the damage of the boom and bust cycle is to cut the problem off at the root by reform of the monetary system that will end the privileges accorded to central banks. Getting government out of banking is the best way to get the banks out of government and to end the disastrous boom and bust cycles that have characterised the last century and a half.

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