A matter of principles
Soon after Lehman Brothers' 2008 bankruptcy, Fed Chairman Ben Bernanke reportedly proclaimed that "there are no atheists in foxholes and no ideologues in financial crises."
Mr. Bernanke likely meant that, in a financial crisis, policymakers shouldn't be wedded to their pre-crisis understanding of what does and doesn't constitute sound economic policy. They should instead react to events as these unfold.
No one objects to policies changing to reflect an improved understanding of the economy. A financial crisis, however, is the worst situation for improving our understanding of the economy. And government officials are the last people to look to for such enlightenment. Panic, puzzlement and political pressures are all super-intense. The only reliable guides through this confusion are principles.
It's not as if we economists have no well-developed theories for understanding economic crises. We do. We also have principled policy recommendations based on these theories.
But in this crisis, Bernanke, panicking, tossed aside his principles.
I use the word "principles" here loosely. True principles aren't abandoned in a storm. The fact that Bernanke and many other government officials so readily pitched aside their alleged principles testifies to the fact that these officials simply aren't very principled.
Prior to 2008, Bernanke's economics was much closer to the free-market school of Milton Friedman than to the faith-in-government creed of John Maynard Keynes. Backed by sound logic and plenty of facts, the Friedman school teaches that markets are not naturally prone to huge downturns; such downturns typically result from unwise government meddling.
And so the cure for such crises is to stop the unwise government meddling. Sure, central bankers must take certain steps during each crisis to ensure that it doesn't get out of hand. These special steps, though, all turn upon ensuring that the money supply doesn't collapse. That's it. Nothing more.
Bernanke, though, went way beyond this prudent step. Blinded by panic (or eager to please the White House and Congress), Bernanke ignored what Carnegie Mellon economist Allan Meltzer calls "the powerful regenerative forces of the market."
Meltzer -- a pre-eminent scholar of monetary policy and the Fed -- understands that government meddling often causes unusually large numbers of people to make unusually bad investments. Although seemingly sensible when made, these investments are doomed because the information that guided these investments was distorted by unwise government meddling in the economy.
There's no way to get the economy back on the right track except to liquidate these lousy investments and allow the market to rediscover better, more sustainable ones.
And it's at this stage that sound principles are especially important.
Liquidating bad investments is painful. Real people suffer real financial losses. These people naturally wish to avoid these losses if they can. And politicians are eager to help them do so because that makes politicians appear to be powerful and good -- and worthy of re-election.
So politicians borrow and print money madly. Today's taxes don't rise and government spends the money, hoping to bolster the falling values of these bad investments.
For a time, this unprincipled policy might succeed -- but this "success" is only brief and illusory. Bad investments aren't turned into good investments simply because government "injects" new "demand" into the economy.
Had a principled economist been chairman of today's Fed, that person's principles would have led him or her to focus on the long-run health of the economy. He or she would therefore have argued against the massive "stimulus" package, knowing that the market economy would rejuvenate itself.
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