A Libertarian Perspective on Economic and Social Policy

Lecture 16

Economic Stability and Growth

©2007 Jeffrey A. Miron

Introduction

• Traditional libertarianism is most often associated with microeconomic issues, and the standard libertarian insights might seem better suited for addressing those kinds of policies.

• Macroeconomic policies are important too, however;– These policies affect the entire economy, so the potential for

benefits or costs are greater than for many micro policies.– And, bad economic times often give rise to bad economic

policies generally.– So, even libertarians might consider intervention to improve the

overall functioning of the economy if this intervention works and promotes better policies in other areas.

• This lecture examines a range of macroeconomic policies from a libertarian perspective.

Introduction, continued

• Despite the fact that issues of “rights,” externalities, and the like are less obviously relevant for macroeconomic issues, I will suggest that the version of libertarianism I have presented in this course – thoughtful cost-benefit analysis – is just as useful for examining macro policies as it is for examining micro policies:– And this approach leads to similar conclusions:– Most if not all interventions do more harm than good.

Outline

• Stabilization Policy• Deficits• Central Banks and Money • Fixed Versus Floating Exchange Rates• The Exchange Rate as a Target• The Balance of Trade• Free Trade• Immigration• Foreign Aid

Stabilization Policy

• Until the Great Depression of the 1930s, the focus of most economics was micro:– The idea that the overall economy could suffer a

general, coordinated decline was not given much attention.

– Instead, analysis addressed the behavior and failures of individual markets, assuming that with a large number of individual markets, some growing and others declining, overall economic progress would be reasonably steady, and any fluctuations would reflect exogenous, unavoidable events such as weather or disease (e.g., the bubonic plague).

Stabilization Policy, continued

• The Great Depression changed this view:– Many economists concluded that capitalist economies

could suffer substantial, prolonged downturns from which they would not quickly recover on their own.

• Macroeconomists therefore developed two things:– A theory of cycles and recessions (based on sticky

prices);– A theory of how policy could reduce or eliminate these

cycles, i.e., stabilize the economy.

Stabilization Policy, continued

• This perspective became the accepted framework in both academic and policy circles.

• The framework suggests that monetary and fiscal authorities should adjust money, interest rates, taxes, and spending in a countercyclical fashion.

• The goal is to smooth out the fluctuations in aggregate output.

Problems with Stabilization Policy:The Lags are Long and Variable

• A basic problem with stabilization policy is that it affects the economy with a lag:– This is partly because it takes time to

recognize that the economy is going into a recession;

– This is partly because it takes time to choose and implement an appropriate policy;

– This is party because it takes time for the chosen policy to affect the economy.

Long and Variable Lags,continued

• The lags would not be an issue if forecasting were easy and if the lags were of fixed or highly predictable length:– Under these assumptions, policymakers can simply start

adjusting policy in anticipation of an expected downturn, thereby smoothing out the cycle.

• In practice, however, forecasting is an inexact science, and the lags in policy are long and variable.

• Thus, attempts at stabilization can easily be counter-productive, i.e., destabilize the economy.– The evidence on whether policy has stabilized or destabilized

does not make a compelling case in either direction.– But it certainly fails to indicate that policy has on average been a

stabilizing force.

Aside: What did We Learn from the Great Depression?

• The Great Depression was regarded at the time as proof that economies are inherently unstable and that stabilization policy is needed.

• In fact, later research (Friedman and Schwartz’s A Monetary History of the United States) argues that a modest recession became the Great Depression because the Fed allowed the money stock to fall substantially:– Thus, F&S claim the Great Depression resulted from bad policy,

rather than being evidence that active policy is desirable.• There is a range of opinion among reputable economists

about the FS hypothesis.– But few deny the possibility that policy contributed substantially

to the outcome.

Long and Variables Lags, continued

• A possible response to the long and variable lags is that policy should attempt to stabilize, but cautiously:– That is, only take action in response to large, obvious shocks,

rather than attempting to fine-tune.– In fact, there is no longer much support for fine-tuning, despite

continued support for some degree of activism.• A second possible response is that, over time, the

uncertainty about policy and the difficulties in forecasting will diminish;– Plus, there will be learning by doing, so it’s useful to practice.

• These arguments are not totally silly, and if there were no other costs to stabilization policy, they might be persuasive.

• But there are substantial other costs.

Problems with Stabilization Policy:Is Smoothing Desirable?

• A potentially important problem with stabilizing the economy is that some fluctuations might be at least partly efficient.– If oil prices rise, it might be good for the economy to

invest in coal-burning technology; in the short run, this reduces growth.

– If a new technology like computers arrives, the economy might slow in the short run as it adopts the new technology.

• This is the Real Business cycle view; if it is even partly right, then smoothing might have a cost even when successful.

Problems with Stabilization Policy:Growth versus Stabilization

• A related problem with the focus on stabilization policy is that it distracts from thinking about growth:– There is a reasonable case that the benefits

of even slightly faster growth swamp any benefits of reduced fluctuations.

– The stabilization view therefore encourages thinking about the less important issue.

Problems with Stabilization:Adding Uncertainty

• A different effect of stabilization policy is that the private sector expends resources forecasting what policy is going to do, instead of just forecasting what the economy is going to do.

• This is wasted effort; the extra uncertainty complicates life for the private sector.

• Indeed, there is a plausible case that some instability arises from the private sector trying to figure out what policy is going to do, rather than from inherent instability.

Problems with Stabilization Policy:Microeconomic Considerations

• One standard tool of stabilization policy is increased or decreased deficits:– Cutting taxes or raising expenditure expands the economy, and

vice versa, so policy can attempt to offset fluctuations by adjusting taxes or expenditure.

• The problem is that taxes and expenditure have microeconomic implications, independent of any impacts on stabilization. That is, – Deficit = G – T

• And we should care about the levels and composition of G and T separately, not just the difference.

• It is possible that policy should consider both effects:– But it certainly should not ignore the micro side.

Deficits and Debt

• The conventional view of budget deficits and government debt is that these are bad things:– In particular, the standard claim is that when the government

runs a deficit it must borrow from the public, which raises interest rates and crowds out private investment.

• This view is reasonable, but it is not the only possible scenario: – Under Ricardian equivalence, deficits have no effect.

• Existing evidence suggests the U.S. economy is some-where between the extreme views.

• So, deficits are probably worth avoiding, or at least keeping in moderation, but they are not as horrible as deficit hawks make them out to be.

Deficits, continued

• How should libertarians feel about current deficits in the U.S.?

• The first reaction should be that current expenditure is enormously too high and should be reduced, even if the U.S. were running a surplus.– If this occurred, the deficit issue would go away.

• A second reaction could be that, even if expenditure is not cut right away, “starving the beast” might help control expenditure over time:– Thus, (virtually) all tax cuts are a good thing, even if

they raise the deficit.

Aside: Hypocrisy Over Deficits

• Liberals used to be the ones arguing for deficits: – The stated reason was a desire to stimulate

the economy, although the real reason was the desire to expand government expenditure.

• Conservatives used to oppose deficits:– They dismissed the stimulus argument and

argued that most additional expenditure was wasteful.

Hypocrisy Over Deficits, continued

• But now things have switched.

• Conservatives want to cut taxes, so they use the stimulus argument as an excuse.

• Liberals do not want to cut taxes; they want more revenue to spend. – So they soft-pedal the stimulus argument

because it is now “inconvenient.”

• Both sides are totally hypocritical.

Central Banks

• If stabilization policy is undesirable, is there a good reason for a central bank?

• No.– Once a central bank exists, it will intervene.– The only intervention that is necessary in connection

with “money” (i.e., the means of payment) is that government must establish what form of payment it accepts in those transactions it conducts.

• This may establish a default “money.”• But everything else can be done privately.• Note that the U.S. got along quite well without a

central bank until 1914.

Fixed Versus Floating Exchange Rates

• A different macroeconomic question that economies confront is whether to have a fixed or floating exchange rate.

• Eliminating the central bank does not avoid this issue, since Treasuries can and do attempt to “peg” exchange rates.

• And it’s an important question for countries that do have central banks.

Fixed Versus Floating Exchange Rates, continued

• This is an easy issue:– There is no sensible case for fixed rates.

• The negative things people associate with exchange rates (e.g., currency crises) can only happen under fixed rates:– Under floating, the rate simply adjusts to changes in

the demand and supply, just like for any other good.

• Moreover, much of the uncertainty about demand and supply occurs because of fluctuations in government policy toward exchange rates and related issues.

The Exchange Rate as a Independent Target of Policy

• A related question is whether policy should care about the level of the exchange rate:– For example, concern that the dollar’s value is “too”

low or that the yuan is overvalued.• All this discussion is utter nonsense:

– It is logically impossible for the central bank to target separately the price level and the exchange rate;

– There is only one instrument, the supply of domestic currency.

• So, the exchange rate is whatever it is, given monetary policy.– Attempts to deny this are muddle-headed at best.

The Current Account Deficit

• In addition to worrying about the exchange rate, countries worry about current account deficits.

• The balance of trade of any country is the record of all its transactions with the rest of the world.

• This balance of trade has two pieces: – The current account, which records trade in goods

and services. It equals exports minus imports and is often referred to as net exports.

– The capital account, which records trade in assets.

The Current Account Deficit, continued

• An inescapable fact of accounting is that the balance of payments always balances:– CA + KA = 0.– In words, if I buy a bottle of wine from France, the

U.S. has a CA deficit but an offsetting KA surplus:– Goods flowed into the U.S. but an asset (the dollars I

spent on the wine) flowed out.– NB: if I first bought francs from France, that was a

wash in the KA.

• The CA and KA do not necessarily balance and in fact are zero only rarely.

The Current Account Deficit, continued

• The question is, should a country care whether its CA is positive or negative?

• If the CA is negative, it means the country is borrowing from the rest of the world.– There is nothing inherently bad about that.

• A CA deficit might be a reflection of underlying problems:– A CA deficit occurs when domestic saving is low.

• So, if there are policies that inappropriately discourage savings, it makes perfect sense to undo those.– But this would be true in a closed economy.– The CA deficit plays no independent role.

Free Trade

• Of all the propositions in economics, the view that free trade is best is perhaps the most widely held. And for good reason: – Barriers to trade such as tariffs or quotas reduce or prevent

Pareto-improving exchange;– And trade has additional benefits, such as providing competition

for domestic industry.

• Are there reasonable arguments for restrictions?– In theory, perhaps, but in practice, no.

• This does not mean trade is always good for everyone:– It adversely impacts low-skill labor in high-wage countries.– But it also helps low income workers through standard channels,

and it makes more sense to redistribute directly, if warranted.

Free Trade, continued

• The libertarian view, therefore, is that any country with trade barriers should remove, unilaterally and immediately.

• The one possible argument against this approach is that, by threatening to retain its trade barriers, a country like the U.S. might convince other countries to reduce theirs.

• This is possible in principle:– In practice, it simply seems to be an excuse for

further delay in removing existing barriers.

Immigration Restrictions

• Until the end of the 19th century, the U.S. had virtually no regulation of immigration.

• During the early 20th century, there was some regulation and a few notorious restrictions enacted (in particular, the Chinese Exclusion Act of 1882).

• But overall, immigration was barely regulated by today’s standards, and immigration rates were high.

Immigration Restrictions, continued

• In the early 1920s Congress enacted a quota system based on national origin; this reduced immigration dramatically through the 1950s.

• In mid-1960s, further modifications gradually eliminated the quota system and simply set limits on numbers of immigrants.

• Over the past several decades this system evolved further. – Now, immigration is allowed mainly because of family

connections, labor market skills, or refugee status.– The total amount of legal immigration is modest by historical

standards; roughly a third the rate (relative to population) of the early 20th century.

Immigration

• Most (rich) economies restrict immigration substantially.

• There is no good efficiency argument for so doing; in fact, such restrictions reduce global efficiency.

• The only argument is distributional:– Existing low-wage workers are likely to lose out as a

result of immigration, which fits with the fact that unions and other low-wage groups strongly oppose relaxed immigrations restrictions.

Immigration, continued

• The libertarian position is that income effects are best addressed, if at all, using other policies such as an NIT.

• Thus, libertarians tend to favor eliminating all barriers to immigration.

• The only possible caveat is that one significant group of beneficiaries – the immigrants – are not (yet) citizens or residents of the country allowing the immigration.– So, some would argue they deserve less weight in the social

welfare calculation.

• Thus, if there were no costs of immigration restrictions, this might be a tough issue.

• But there are such costs.

Costs of Immigration Restrictions

• Like all prohibitions, those on immigration generate black markets, with all the standard negative effects:– Violent dispute resolution– Disrespect for the law– Rewarding the relatively dishonest– Corruption– Reduced “product quality”

• Plus, there are direct costs of enforcement.

Immigration and Security

• A different argument for restricting immigration is that this is necessary to “keep out terrorists.”

• But the restrictions do not work particularly well:– Tons and tons of illegal drugs enter every year– Hundreds of thousands of illegal immigrants enter

every year

• It is hard to see how a determined terrorist is affected by any enforcement regime we can imagine.

Foreign Aid and Lending

• In addition to trying to manage their own economies, some countries (the rich ones) attempt to manage developing economies.

• The main mechanism is organizations like the IMF and the World Bank, which lend to poor countries “conditional on” adoption of the “right” economic policies.

Foreign Aid and Lending, continued

• This policy sounds sensible in theory; the practice is much tougher.

• First, stabilization policy is difficult at best, as discussed above.

• Second, ensuring that the recipient countries follow these policies is hard.

• Third, there is much scope for diversion of the funds to bad purposes.

• Fourth, the incentives of the IMF, WB are to keep making loans, not to be “tough.”

Foreign Aid: Grants

• It might seem that even if rich government lending to poor countries is problematic, unrestricted grants cannot help but make the recipient countries better off.

• In practice, there is no evidence that foreign aid helps.

• This might seem counterintuitive, but there are plausible explanations.

• Most importantly, the availability of “free money” provides an excuse for not adopting good policies, most of which countries could do on their own.

Conclusions

• Eschew active stabilization policy.• Choose spending levels and tax programs

based on efficiency considerations.• Eliminate the Fed; fix the money stock at

whatever it is now (or adopt a rule).• Let the exchange rate float.• Ignore the exchange rate and the CA deficit in

making policy.• Free trade, unrestricted immigration.• Leave other countries alone.