Thursday, May 15, 2008

Government policies and outcome uncertainties

Peter Bernstein argues in favor of pro-active Government policy intervention to stabilize aggregate demand and employment, instead of standing by and letting the market forces play themselves out.

In many ways, it is as much a challenge managing prosperity as it is managing an economic crisis. As the recent famous example of the "Greenspan put" highlights, it is almost impossible to know the right time and extent of policy intervention required (in this case lowering interest rates), that while sustaining the economic growth would not cause the economy to overheat. Did Greenspan cut the rates too low and hold it low for too long, and thereby let the financial market bubble grow out of control? Is Bernanke making the same mistake now, albeit in a crisis?

Opponents of intervention to stabilize an economy argue that "creative destruction" is necessary to weed out the excesses and inefficiencies. Further, government intervention policies are fraught with information assymetry problems and have the potential to generate moral hazard problems. They therefore favor a policy of letting the market dynamics work themselves out.

Mark Thoma makes out a case for government intervention to stabilize the economy. He argues that the challenge is to identify the economy's natural rate of output (its normal production possibility frontier) and unemployment rate, so as to tailor policies to bridge the deficit. Worse still, since policies generally realize their full impact with a time lag, we need to estimate what would be the natural output rates two or three years down the line.

He describes this situation as being similar to "shooting at a moving target with very slow bullets, and the movements in the target aren't always easy to predict". What makes this even bigger challenge is the fact that "not only does the target move, output moves on its own as well".

Mark Thoma describes the problem thus, "Even if there is no policy intervention at all, eventually output would recover to the natural rate. So if policy is relatively slow as compared to the self-healing process, then policy is likely to do more harm than good. This is why we devote so much energy to trying to find out how much time it takes for policy to impact the economy, and to determining how fast the economy can overcome frictions that prevent it from staying at full employment continuously."

Even if it is clear that the economy would recover faster with policy interventions, the challenge remains to determine the exact size and timing of the policy intervention, besides the policy diagnostics themselves. He sums up the dilemma, "Give the economy too much of a policy shock and you overshoot causing inflation, too little and output will be too low leaving people unemployed. Further, it's hard to readjust and fine tune as you move forward due to the lags and moving targets, and this often results in a fairly conservative intervention, one that attempts to avoid making big mistakes."

This is the dilemma facing Central Banks in a slowing economy (and even a booming economy) which is experiencing inflationary pressures. The question is whether to raise interest rates, and if so when and by how much? Similarly, faced with a cost-push inflation scenario, Governments have to make the choice of fiscal concessions (among other policy choices) - lowering import and raising export duties - so as to ease supply side constraints and increase supply. Again the dilemma is by how much and when? That these are difficult judgements to make does not mean that we abstain from making the decision itself. If that were the logic it would be impossible to exercise fiscal and monetary policy choices at any time!

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