The Make-Believe Economy?

According to Tyler Cowen: “The fundamental cause of the financial crisis has been people and institutions thinking they are wealthy than they are; this spread to Europe as well and now we are seeing the comeuppance.”

I’m not half the economist that Cowen is, but let me offer the following general observation. One consequence of the widespread adoption of the mixed economy—regulated capitalism plus welfare state—is that people who identify themselves as free marketers or classical liberals end up playing both sides of the coin. When times are good, the United States and the West more generally count as capitalist success stories and nobody is wandering around in 2006-2007 talking about how apparent prosperity is merely an illusion. But when things take a dark turn and events appear to justify dramatic government policy interventions, suddenly the story changes. Now instead of robust market economies the world is suddenly full of fragile socialist wrecks that’s can’t grow as fast in the future as they did in the past, and indeed couldn’t even grow that fast in the past. Prosperity is and was an illusion, and the only effective policy interventions would be dramatic, politically toxic reforms.

I don’t buy it. I can’t prove it’s wrong, but I don’t buy it. I think growth trends are robust but macroeconomic stability requires active policy management. Recessions reflect failures of macroeconomic stabilization policy. Big recessions reflects big failures. Look at the incredible stability of US per capita GDP growth when plotted on a log scale:

[US+GDP+-+Long+Run 1

The exception, of course, is the Great Depression. And while the Depression was underway, politically conservative economists were deep in the grip of a version of real business cycle theory—of the idea that the prosperity of the 1920s had been an illusion and the Depression was our comeuppance. But in the real world, as soon as flawed overcomplacent policies were fixed, growth returned to the trend level. I had thought that one of Milton Friedman’s great achievements was crafting a version of the policy failure story that had adequate rightwing/free-market branding so that we could now create a political consensus around a spectrum of stories ranging from Keynes’ to Friedman’s but in all cases emphasizing that timely and forceful policy interventions can break these cycles. But somehow the Great Recession has fractured that consensus and a lot of the sort of people who you’d generically expect to say nice things about Friedman have reverted back to a pre-Friedman, Hayek/Schumpeter-style story in which our prosperity was just an illusion.