Can Government Manage the Economy?

Can Government Manage the Economy?
by The Freeman on Tuesday, February 1, 2011 at 12:01am

A doctor says he can cure illness by waving birch wands over the patient. We are skeptical, but being open-minded, we agree to give him a chance with ailing Uncle George. He waves a red wand and chants something. The patient shows no improvement.

"Let me try a green one," he says. We're still tolerant. The new wand is waved: afterwards, dear George is decidedly worse.

"Let me think," the healer says. "Maybe it should be a purple wand and a different chant."

For 98 years the federal government has been attempting to prevent asset bubbles, recessions, and spasms of unemployment. In 1913, Woodrow Wilson created the Federal Reserve System, telling the country that this new institution would be "a safeguard against business depressions." In 1929, with the Fed in operation for 15 years, the United States plunged into a deep depression.

Okay, so maybe red wands don't work, and we should try green. Politicians of the 1930s created more bodies designed to stabilize the economy and build investor confidence: the Federal Deposit Insurance Corporation, the Federal Savings and Loan Insurance Corporation, the Securities and Exchange Commission, and the National Credit Union Administration. The Depression deepened, becoming by far the longest and deepest economic downturn in the history of the United States.

This is the national pattern in economic policy: in the face of failure, we keep looking to government. Since the Great Depression, we've added more units designed to curb inappropriate behavior and ward off recession, including the Commodity Futures Trading Commission (1974), the Federal Financial Institutions Examination Council (1979), the Working Group on Financial Markets (1988), and the Office of Thrift Supervision (1989). Yet in 2008 we fell into another economic downturn.

This 2008 recession was triggered by the boom and bust in the housing market. Was housing an unregulated market where government had failed to intervene? Sorry: There were seven agencies supposedly nurturing this industry:

1. Federal Housing Administration (1934)

2. Federal National Mortgage Association (Fannie Mae) (1938)

3. Government National Mortgage Association (Ginnie Mae) (1968)

4. Federal Home Loan Mortgage Corporation (Freddie Mac) (1970)

5. Neighborhood Reinvestment Corporation (1978)

6. Federal Housing Finance Board (1989)

7. Office of Federal Housing Enterprise Oversight (1992)

In sum, at the onset of the 2008 recession there were 16 units of the federal government that were supposed to manage economic life and keep us from harm, yet harm befell us. No wand-waving faith healer has ever failed so conspicuously.


Ruled by Illusions

Alas, economic policy is not a drug trial; it is politics, and politics is ruled by illusions. In June 2009 we find President Barak Obama urging the creation of yet more government units to manage the economy, promising that his reforms will "make sure that these problems are dealt with so that we're preventing crises in the future."

We can't be too critical of Obama, because many others share this confidence in government regulation. "Without intervention by the government," say economists George Akerlof and Robert Shiller in their 2009 book Animal Spirits, "the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos." It's an astounding non sequitur: to assert that government can prevent crises, recessions, and "swings in unemployment" while being fully aware that for 98 years it has been trying to do it and failing.

A powerful subconscious bias is obviously at work here, a mental distortion that prevents normal, intelligent people from being able to learn from experience. I call it the watchful eye illusion: the idea that government has greater knowledge and wisdom than the public. In extreme form this illusion treats government as God, as a superior being, who, from His Olympian position, surveys the scene and controls error and wrongdoing. Once this illusion is locked into your thinking, you remain convinced, despite any amount of failure, that government has the ability to do things right next time.

It appears that this fallacy begins in childhood. Youngsters see that their lives are guided by people who are more thoughtful and mature than they are: their parents. If they challenge the parents ­ asking, in effect, what gives you the right to make rules over me? ­ the parents say they know more. When children first learn about government, they see it as a super authority ten times more powerful than parents. Naturally, they assume it must have ten times their parents' wisdom and foresight.

Many do not outgrow this perspective; they carry into adulthood the idea that government is a super-parent. Economists Akerlof and Shiller accept this view, declaring that it forms the core of Keynesian economics:

The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits. But those limits should also allow the child independence to learn and to be creative. The role of the parent is to create a happy home, which gives the child freedom but also protects him from his animal spirits. This happy home corresponds exactly to Keynes' position (and also our own) regarding the proper role of government.


Ordinary Beings

There are two fallacies in the Keynesian view that government can be a "parent" watchfully guarding over the national economy. First, the politicians who run government don't have superior wisdom and maturity. Government officials are ordinary fallible human beings. They can be careless, inattentive, and shallow. They can be swayed by emotion. And sometimes they can be dishonest and corrupt.

The second fallacy is that the public is not an ignorant child. The economy's millions of individual businessmen and investors have, collectively, vast wisdom about economic possibilities and trends. These individuals pour their knowledge into their market behavior, thereby setting the prices of assets, goods, and services. Left free to suffer the consequences of their decisions, investors and entrepreneurs will develop systems for managing risk and for evaluating the validity of investments. These systems won't be perfect, of course: There will be errors, bubbles, and frauds, but from these errors, the community learns to improve decisions in the future.

This system of social learning is short-circuited by government intervention, with its subsidies, bailouts, changing rules, and false promises to protect everyone. In truth, the greatest long-run threat to the health of the economy is the chaotic meddling of eager politicians whose intellectual powers have been so naively overrated by academic economists.