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Whither Stabilization?

October 6, 2008

A recurring meme in the mainstream bailout chatter is the idea that the government should intervene to “stabilize” the financial system. After all, the odious piece of legislation rammed through Congress last week was titled the “Emergency Economic Stabilization Act of 2008.” Today, the AP reports, “President Bush’s top economic advisers vowed to work with their counterparts around the world to restore confidence and stability to financial markets roiled by tight credit and worries about a global economic slowdown.” The Treasury Department is even calling its new bailout czar, introduced today with great fanfare, the Interim Assistant Secretary of the Treasury for Financial Stability. (Oh, he happens to be a former Goldman Sachs executive, but never mind.)

The larger context is the long-held, Keynesian belief that government intervention through monetary and fiscal policy, combined with a massively regulated and subsidized banking sector, reduces the “natural” volatility of the free market. One analyst I heard on NPR last week said something like this: “I’m confident we won’t have another Great Depression, because back then, no one knew what was going on, but now, the government knows exactly what’s happening and is ready to step in and fix the problem.” From the 1950s to the 1980s it was an article of faith among the cognoscenti that business cycles were much less severe than before the mid-twentieth century when both discretionary and “automatic” stabilizers (like unemployment insurance) became embedded in national policy.

However, even mainstream macroeconomists are unsure that the economy is any more “stable” today than in the days before Keynes. The Keynesian consensus was challenged by Christina Romer (and others) in the 1980s, and 1990s, particularly in Romer’s “Is the Stabilization of the Postwar Economy a Figment of the Data?” (American Economic Review, June 1986). She attributes the perceived smoothing of the business cycle to changes in how output is measured, not any structural change in the economy. You can read more in Romer’s summary article in the Spring 1999 Journal of Economic Perspectives and her entry on business cycles in the Concise Encyclopedia of Economics.

Of course, doubts about the effectiveness of Keynesian stabilization policy have not dampened most macroeconomists’ enthusiasm for, well, Keynesian stabilization policy.

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