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Last week I noted that Bryan Caplan, like many libertarians (and conservative economists as well), operates under the assumption that the data doesn’t support the Keynesian view of the economy. I put up a few graphs showing he is in error, and that growth rates are, in fact, lower when libertarian and conservative economic prescriptions are followed. But the problem is worse than one of slightly slower growth – that would simply mean we’re all just a little poorer than we otherwise would be. The problem is that every so often, bad policies leads to an outcome worse than just slightly slower growth.

Consider something I wrote back in March of 2008:

Think back to January of 2001. Say you told any conservative or libertarian that there would be what the White House refers to as a “mild recession” later that year. Say you also told that conservative or libertarian that by the beginning of 2008, the economy would have enjoyed years of tax cuts, years of cheap money coupled with low inflation, years of reduced regulation, and a couple (semi-privatized) small wars. Would they have predicted that along the way, real growth would be sub-par, and right now we’d be facing the possibility of a major downturn? Could they have even accepted that combination of facts? Is what we’re seeing a feasible outcome of any conservative or libertarian model?

Sure, we’ve all heard the arguments that the Community Reinvestment Act went a long way toward causing the meltdown, but there are three problems with that. The first is that even if the CRA bore some responsibility, it was passed in 1977, and that wouldn’t change the paragraph above – CRA or no CRA, there were years of tax cuts, cheap money coupled with low inflation, reduced regulation and a couple of semi-privatized wars. If the CRA was the problem and not lack of oversight, presumably the Great Recession would have happened during an administration that, say, did a less thorough job of deregulating and tax cutting. A second problem with blaming the CRA is that the economic mess is due to banks loaning money to people who shouldn’t have borrowed or been allowed to borrow, and there was no policy or law that forced a single organization to make loans it shouldn’t have or any entity to borrow money it shouldn’t have. A third problem is that the Great Recession struck many other countries as hard or harder than the US. One thing that was common about many of the worst hit countries is that they were high on the list of recent (say, in the past ten years or so) success stories as told by the folks who like to blame the CRA for the mess.

In any case, what is interesting that the paragraph I wrote in March of 2008 could have been written in October 1929. Sure, the semi-privatized small wars from the 1920s were mostly in Guatemala, Honduras and Panama, and the eight years of tax cuts and deregulation saw two Republican Presidents rather than one (Harding & Coolidge v. a single Bush), but on the economic front, things were quite similar. Sure, the NIPA data doesn’t go back that far, and the 20s do have a sterling reputation when it comes to growth (the Roaring 20s, dontcha know) but that only goes to show that the folks who were doing well at the time were the ones to write the history books. For everyone else, the Roaring 20s was a period where the economy could barely stay out of recession, denoted by the gray bars below:


Figure 1.

Data sources for the graph are described in the post where the graph originally appeared. And as I noted in that post:

in the 96 months between the end of the 1920 Depression and the start of Great Depression that followed this tax cutting bonanza, the economy was in recession 30% of the time

Incidentally, I can also think of one other period during the past 100 years which can also be described as several consecutive years of deregulation and tax cuts: the Reagan administration. That too ended poorly, though the price for the resulting S&L debacle was only paid during the administration of Bush the Elder, and it was spread over an extended period of malaise so nobody thinks of cause and effect.

All of which brings me back to where I started. The policies advocated by libertarians and economic conservatives not only tend to be accompanied by slower growth in general, as I noted last week, but also tend to precede economic meltdowns. All of which leads to a few possibilities:

1. Libertarians and economic conservatives are dead wrong; policies they advocate should tend to lead to worse outcomes than policies they are against
2. Libertarians and economics conservatives are mildly wrong; in general, whether the policies they advocate are adopted or not won’t have much of an effect on economic growth and its just a coincidence that in periods where their policies are adopted, outcomes tend to be worse
3. Libertarians and economics conservatives are right. As a result, the fact that outcomes tend to be worse in periods where their policies are adopted is just the result of a large number of very unlikely events.

Assuming folks like Caplan actually know what the data says and aren’t advocating positions out of complete ignorance or worse, ill will, they seem to be arguing for position number 3. From a logical perspective, its far less likely to be true than the other two positions. Presumably that should put the onus on him (and those who agree with him) rather than those who advocate a position requiring much less heroic assumptions, such as position number 1.

10 Responses to “In Response to Bryan Caplan et. al., Part 2 – Unanticipating The Great Depression and the Great Recession”

  1. [...] In Response to Bryan Caplan et. al., Part 2 – Unanticipating The Great Depression and the Great RecessionCross-posted at the Presimetrics blog. [...]

  2. Ryan F. says:

    You can slam the door much harder on the frivolous CRA theory –

    http://www.frbsf.org/publications/community/cra/cra_recent_mortgage_crisis.pdf

    And the Fannie Mae/Freddie Mac theory as well –

    http://www.fhfa.gov/webfiles/16711/RiskChars9132010.pdf

  3. TheNumeraire says:

    “Say you also told that conservative or libertarian that by the beginning of 2008, the economy would have enjoyed years of tax cuts, years of cheap money coupled with low inflation, years of reduced regulation, and a couple (semi-privatized) small wars. Would they have predicted that along the way, real growth would be sub-par, and right now we’d be facing the possibility of a major downturn? ”

    The tax cuts did not take effect until 2003, from which point growth pr capita was strong. Many conservatives like Bruce Bartlett, Alan Reynolds and the late Jude Wanniski criticized the 2001 marginal rate reductions for being phased in rather than being immediate and for consisting of tax cuts that have no supply-side incentives (i.e. child tax credit). The tax cuts on capital gains and dividends had immediate impact but again were roundly criticized for have sunset provisions, meaning that they would have less impact as the sunset date approached (much like how an option premium suffers time decay as it moves closer to the settlement date).

    Most supply-side conservatives do not look upon ‘cheap money’ as a benefit, in actuality a stable, noninflationary dollar that holds steady value against gold and commodities is much preferred. The stable dollar is what helped to support the post-WWII Bretton Woods era economic growth as well as the 25 year economic period that began in the early 1980′s and was referred to as the Great Moderation.

    By 2005-2006 it was no longer proper to say that inflation was low, as the dollar began rapidly losing ground against gold and commodites. By 2008, rapidly increasing inflation was more than obvious to even the common man. With the trend of an inflationary dollar resuming itself in the past 12 months, inflation figures will continue to climb.

    Some libertarians (most notably Arnold Kling) have written extensively that much of the financial crisis is not owing solely to deregulation, but also to how new regulations (Basel II, ratings-based credit instruments) provoked a form of regulatory capital arbitrage by which financial institutions structured themselves to best take advantage of the new regulations. Kling goes into great detail as to how this regulatory capital arbitrage took place — his papers can be found on the same web blog as Bryan Caplan’s work.

  4. TheNumeraire says:

    “Say you also told that conservative or libertarian that by the beginning of 2008, the economy would have enjoyed years of tax cuts, years of cheap money coupled with low inflation, years of reduced regulation, and a couple (semi-privatized) small wars.”

    One could also invert this line of reasoning to criticize present day big-government policy and it failure to deliver bigtime economic recovery and growth;

    Say you told any progressive demand-side liberal that by the end of 2010 the economy would have enjoyed unprecedented levels of peacetime government spending and Keynesian stimulus, unprecendented cheap money and additions to the monetary base, more regulation and government involvement in sectors ranging from finance/banking, auto production and health care. Would they have expected subpar real growth?

  5. TheNumeraire says:

    “and the 20s do have a sterling reputation when it comes to growth (the Roaring 20s, dontcha know) but that only goes to show that the folks who were doing well at the time were the ones to write the history books. For everyone else, the Roaring 20s was a period where the economy could barely stay out of recession, denoted by the gray bars below:”

    Unemployment in the 1920′s was scarcely ever above 5 percent. Wages grew rapidly (see the BLS research link below), workman’s compensation and group insurance was already in the mainstream and the price level was stable (nominal income gains were equal to real income gains). Contrary to your caricature of the time, the majority of the population saw an increasing living standard.

    http://www.bls.gov/opub/cwc/cm20030124ar03p1.htm

    Agriculture suffered on a relative basis, but that was partly because of the incredible surge in farm productivity and the end of WWI and the resulting decline in total production and farm exports (as well as the end of artificial government price supports for export crops like wheat). History shows that the period prior to the Roaring Twenties (1896-1920) was a time in which agriculture greatly outperformed the rest of the economy.

    Productivity of large-scale farming was greatly aided by the advent of the tractor and crop duster. Farm technology also displaced animal husbandry, which made for lacklustre times for hay farmers and horse breeders. Of course, rapid farm productivity meant that agriculture was undergoing a shift away from labor intensity and small-scale practices, meaning a necessary shift of a segment of the population away from farming. However, this temporary displacement due to productivity and technology is hardly what one would call the result of a dire economic circumstance.

  6. Mike Kimel says:

    The Numeraire,

    I’ve noted at Angry Bear that you and I don’t share the same version of reality, by which I mean our difference is greater than just opinion, it is a difference of facts. I mean, its one thing if we disagreed on basic facts once in a while; that would be a sign that one or the other made a simple mistake. But you bring up so many facts that just don’t fit what I can find on the public record, and seem so certain of them, that I have to assume we live in alternate universes.

    For instance, the first thing you bring up is this:

    “The tax cuts did not take effect until 2003″

    In my version of reality, the IRS publishes this table: http://www.irs.gov/taxstats/article/0,,id=175910,00.html.

    The table plainly shows:

    highest marginal tax rate in 2000 > highest marginal tax rate in 2001, highest marginal tax rate in 2001 > highest marginal tax rate in 2002
    highest marginal tax rate in 2002 > highest marginal tax rate in 2003

    That in turn implies that “The tax cuts did not take effect until 2003″ is an incorrect statement.

    Where does the data in your version of reality come from?

    OK. I’m being facetious, but seriously, it helps to start from the same baseline, and simply put, the tax cuts began taking effect in 2001.

    As to the whole “ratings-based credit instruments) provoked a form of regulatory capital arbitrage by which financial institutions structured themselves to best take advantage of the new regulations.” – that may be true. But that doesn’t mean the government forced anyone to engage in stupidities. For instance, there is a mortgage interest tax credit, but I nevertheless managed to avoid buying a home until after the crash, having reached a conclusion that home prices were unsustainable.

    Then there’s this:

    “Say you told any progressive demand-side liberal that by the end of 2010 the economy would have enjoyed unprecedented levels of peacetime government spending and Keynesian stimulus, unprecendented cheap money and additions to the monetary base, more regulation and government involvement in sectors ranging from finance/banking, auto production and health care. Would they have expected subpar real growth?”

    I was telling everyone I could that we were going to have subpar real economic growth from the moment I saw the Bush administration’s economic blueprint, and I was expecting the debt to explode. So yes, I at least was expecting it.

    The way I framed the question in the post is the way most Republicans & Libertarians were expecting things to be in 2001 and even 2004. (Remember – in 2004 there were still minions at the National Review talking about how GW could be Mount Rushmore material. He wasn’t seen as a “non-conservative” until his policies didn’t deliver. What changed was not his policies, but that they learned they didn’t like the outcome.

  7. TheNumeraire says:

    “That in turn implies that “The tax cuts did not take effect until 2003″ is an incorrect statement.”

    It’s not incorrect. The 2001 cuts were phased in, with overwhelmingly the largest deductions taking place in 2003. The 2003 cuts in capital gains and dividends were made immediate.

    “But that doesn’t mean the government forced anyone to engage in stupidities.”

    Greater incentive to strucuture their capital in such a manner. Ratings-based securities were given capital preference and as such banks held an increasing share of such instruments (especially MBS). Much of the securitiations were not even sold to investors but rather exchanged amongst banks as a means of complying with regulatory capital requirements. Kling (citing comments made by the Shadow Financial Regulatory Committee in 1998) suggests that banks should have more capital in the form of subordinated debt rather than financial instruments. Basel II and U.S. coordinated policy instead took the credit-ratings based approach.

    “He wasn’t seen as a “non-conservative” until his policies didn’t deliver. What changed was not his policies, but that they learned they didn’t like the outcome.”

    Again, many prominent supply-side conservatives did criticize aspects of his policy (especially the falling inflationary dollar, the social policy styled portions of the tax cuts, Medicare part D, sunset provisions on tax cuts), so you are essentially creating a strawman in insisting otherwise.

  8. Mike Kimel says:

    The Numeraire,

    “It’s not incorrect. The 2001 cuts were phased in, with overwhelmingly the largest deductions taking place in 2003. The 2003 cuts in capital gains and dividends were made immediate.”

    Holy wow. So because the estate tax, which was cut every year until it hit zero in 2010, didn’t reach the end point until 2010, you would say there was no estate tax cut until this year? Seriously? Nothing happens at all until it is completed? Does this apply to the non-economic sphere? Would you say an eleven year kid is not considered to be in school because its not the year he graduates from law school?

    “Greater incentive to strucuture their capital in such a manner.”

    Yes, but as I noted, greater incentives don’t force anyone to do something stupid. Or you’re saying the management of these private sector institutions like CountryWide and Bear Stearns and Lehman and AIG and the rest of them simply react to incentives and thus aren’t capable of making rational decisions?

    “Again, many prominent supply-side conservatives did criticize aspects of his policy (especially the falling inflationary dollar, the social policy styled portions of the tax cuts, Medicare part D, sunset provisions on tax cuts), so you are essentially creating a strawman in insisting otherwise.”

    I’m going to ignore the rest of this and focus on the criticism of the shape of tax cuts by the supply siders… because you are engaging in bait and switch here. They weren’t complaining that there would be tax cuts or that the tax cuts wouldn’t boost the economy, merely that they thought a different shape of tax cuts would be more effective.

    Find me the one supply sider who looked at the first quarter of Bush’s Economic Blueprint published at the end of February 2001 and said: “This is going to cause the debt to explode and screw up the economy.” See, I said exactly that when I read it.

    Your arguments read like those of a Politburo member of the 1920s arguing in a freezing corner of a barracks in a Siberian gulag in 1940, that it isn’t fair to judge the Soviet model by how the Soviet Union turned out because they went down Stalin’s route rather than Trotsky’s route. Worse, you’re arguing that to some poor bastard you yourself condemned to the gulag yourself during your own hey day.

  9. TheNumeraire says:

    “Holy wow. So because the estate tax, which was cut every year until it hit zero in 2010, didn’t reach the end point until 2010, you would say there was no estate tax cut until this year? Seriously? Nothing happens at all until it is completed? Does this apply to the non-economic sphere? Would you say an eleven year kid is not considered to be in school because its not the year he graduates from law school?”

    Of course it is important when the bulk of the tax cuts took effect. The argument is no different from that of Keynesian stimulus proponents who advised not to judge the 2009 federal stimulus package too quickly and harshly because the bulk of the spending had not taken place. The juvenile analogies you’ve given do little to bolster your argument.

    “Yes, but as I noted, greater incentives don’t force anyone to do something stupid. Or you’re saying the management of these private sector institutions like CountryWide and Bear Stearns and Lehman and AIG and the rest of them simply react to incentives and thus aren’t capable of making rational decisions?”

    Trends form on the margin and marginal behavior is greatly shaped by incentive. Besides, it was not only U.S. cowboy capitalists that structured their institutions in this manner — European banks did so under the incentives of Basel II and were actually counterparty with AIG in non-collateralized swaps more than U.S. institutions.

    “Find me the one supply sider who looked at the first quarter of Bush’s Economic Blueprint published at the end of February 2001 and said: “This is going to cause the debt to explode and screw up the economy.” See, I said exactly that when I read it.”

    No prominent supply-sider would have been able to gauge that an economic blueprint from 2001 would cause or have anything necessarily to do with an economic contraction that took place 7 or 8 years later. There were plenty of warnings along the way about the efficacy of social policy styled tax cuts, the rapid increase in federal spending and entitlement expansion, the falling dollar — some like Jude Wanniski even openly opposed the Iraq war.

    I’ll bet that the degree to which you did warn in 2001 with such supposed clairvoyance came in the following context;
    a) you imagined that economic problems would be closer to imminent rather than lagged by 7 years
    b) you (and your Angry Bear colleagues) were caught off guard by the real per capita growth that took place in the years following the 2003 tax cuts
    c) you were not expecting budget problems to arise from such a rapid rise in federal spending and were instead anticipating ‘starve the beast’ philosophy that a branch of conservatives preach
    d) you ignored that by 2006, real federal revenues has surpassed 2000 levels, but deficits persisted because real federal spending grew by almost 30 percent

    “that it isn’t fair to judge the Soviet model by how the Soviet Union turned out because they went down Stalin’s route rather than Trotsky’s route.”

    Stalin and Trotsky’s routes are closer to your world view than mine. It’s not even a reasonable analogy of the Bush presidency. Bush did not chose between two closely tied ideologies; he mixed together two radically different ones. Supply-side tax cuts combined with demand-side tax rebates and social policy tax credits. Small government rhetoric countered with government largesse and entitlement expansion. Ignorance towards the damage caused by a falling inflationary dollar, practically urging the dollar to fall in value. I can’t say I’ve read the 2001 Economic Blueprint, but I’ll bet the rhetoric contained within it does not resemble the actual outcomes and legislative action taken over the full Bush presidency

  10. The banksters could have worked on beneficial solutions with the homeowners. Instead, they chose to pay people to commit forgery. I would not doubt that they will now send the paperwork overseas, so that it is not processed in English.

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