Economic Policy: Treating Symptoms, Treating Causes?

Mike Smitka

...Inaction is the Best Medicine?...

The question: can we use an analogy from medicine, that we should treat the disease rather than the symptoms?

1. Of course treating the common cold or a mild case of the flu may not be worth the effort (tamiflu?!) -- take 2 aspirin, drink lots of fluids and go to bed.
   
2. Where there is no direct treatment, or the symptoms themselves are dangerous (and the diagnosis pending) then treating symptoms may be the best policy. That's the standard plot on House, someone's dying, treat the symptoms while the detective work progresses. Of course, to fill up the hour the first choice backfires (or works but then new problems crop up).
   
3. Sometimes though the effects of the disease don't, or won't ever, reverse themselves. The stroke is over, blood is flowing but...or the rheumatic fever has subsided, but the heart valve is shot and won't heal itself. Treat the aftereffects, not the cause.
4. The patient may not cooperate. In the (really) old days of cable bindings skiers broke bones with alacrity. You could set the bone and mostly get it to heal. But keep on skiing ... well, you haven't treated the disease and next time it may be a joint that can't be fixed. I suppose a better example is obesity: few doctors will tell someone "get lost until you lose weight." Now it's good for business, and many patients may be too addicted to snacking and watching TV to shift their net caloric intake (fighting alcoholism may be easier, after all our bodies can survive without drinking, but you can't stop eating). In economic terms, political economic calculations may mean you know what you ought to do, but don't.
   

So in fact when I think more deeply about the medicine analogy, it suggests there is no quick answer for what an economist ought to propose.

I still hold that best practice remains diagnostic-based treatment. But let me return to the list above.

1. Being reticent to act is not a bad thing. There are always "shocks" to an economy, good and bad, but in developed countries our economies are both very big and resilient. The effect of most shocks is transient, even when the impact can with hindsight be discerned in the data. Policy has side effects, it can be hard to change and hard to reverse if it creates "winners" (an example is the capital gains tax exemption in the US, originally put in as a response to the distortions caused by the late 1970s inflation). In the macroeconomic context, textbook models suggest that adroit fiscal and monetary policy can eliminate the business cycle, but getting the timing right is hard because the "normal" cycle is short (reverses itself) and we tend to use the wrong policy tools (monetary policy to slow an economy, fiscal policy to boost -- the opposite is ideal). So we have both side effects (higher real interest rates coming and going) and may be giving the wrong medicine (no need to push down body temperature once the fever's gone).
   
   The losses from Japan's earthquake were horrific and even if we can rebuild, we reverse death or undo privation. But from the perspective of the economy as a whole it was still a fairly small event, and even if Toyota and Honda lost a lot of production, rivals were less affected. So the underlying competitiveness and complexity of a modern economy means there are lots of substitutes. So while there was a short-term impact there's no reason that macroeconomic policy need change. (But every reason to devote resources to recovery...at the local "microeconomic" level.)
   Back to the practical problems of real-time policymaking. This was Milton Friedman's bete noire -- after all he used the same Keynesian analytic framework, so it was not theory that drove him but pessimism about policy makers and the policymaking environment. He wanted a world of rules. Unfortunately the world proved too complex for simple rules, which he himself recognized in his latter years. As long as we permitted innovation in financial services, rules would need to evolve. Ideological correctness is insufficient: with irony, it was Greenspan the conservative/libertarian who poured fuel on the flames of a financial system fixated on short-term returns while trading long-term instruments. Financial innovation provided insurance policies, yes, but not as fast as financial innovation multiplied risk.
2. Does the economy always quickly recover? Clearly, no. We should be chary of panicking at every sign of recession or the cry of inflation that comes every commodity spike (we are wont to confuse shifts in relative prices from aggregate inflation when it comes to the prices of gasoline and veggies.) That's point #1.
   
   But neither should we bury our heads in the sand and say things will pass when all evidence speaks to the contrary, when unemployment or inflation is suddenly a multiple of desirable and presumably feasible levels.
   So when the patient may be dying, provide stimulus. If that doesn't work, provide more. It's not hard to back off of emergency measures -- the Civilian Conservation Corps was folded pretty quickly. [President Eisenhower found it harder to trim the War Department, by then artfully renamed the Department of Defense, but its growth was never premised upon macroeconomic necessity, even though commentators from at least the 19th century had pointed out that wars on other people's land weren't so bad, particularly when in the post-draft era they are from a policymaker's perspective fought by other people's children.]
   Keynes in fact was a good example. On matters economic he was a conservative, but he had warned about the large macroeconomic flows built into Treaty of Versailles reparations as something that would be beyond the bounds of normal macroeconomic adjustment. Then, in the 1930s, he found himself staring at 20% unemployment in Great Britain, well, it was clearly not a run-of-the-mill downturn. Worse, he was looking into the abyss of socialism -- in Germany, the National Socialist Party of Adolf Hitler, and there was populism and radicalism at home.  Something was sorely amiss, and sitting on his hands wasn't an option, even if as the creator of modern macroeconomics he was at times groping and unsure of his way (or more precisely, incoherent.) Keynes didn't view his task as that of a plumber fixing the odd leak along a dike; he saw a dike about to collapse with raging floodwaters set to inundate hist beloved England.
3. Macroeconomic damage is fundamentally irreversable. If you've lost your job and can't find one for 9 months, it becomes increasingly difficult in many industries to get hired back to a similar position. You can never make up for lost consumption -- the pain of telling kids "no" can't be undone. When it lasts long enough, small businesses fail and teachers get fired and roads don't get maintained and communities lose coherence. If you've lost your house, it can take a while to rebuild your credit rating, not to mention build up the downpayment on another house. And if in the interim you've been unable to afford healthcare and haven't been able to pay college tuition, there's long-term damage. These affect society as a whole, too, and not just those hit directly by economic trauma. So while we may not be sure what's causing unemployment, we certainly can engage in direct job creation or pay extended unemployment benefits and offer subsidies to state and local school systems and hospitals to mitigate the side effects of recession.
4. A financial system that collects fees up front for selling assets that are long-lived has a built-in conflict of interest. Straight bank loans to small businesses are less problematic, because they tend to have a shorter maturity (lessening the mismatch between the time horizon of a bank's assets and liabilities) and because banks can't sell such loans to others as readily and so are more careful in their decision-making. (Asides: the 90-day line-of-credit is illusory, since most businesses structure themselves as ongoing entities; maturity mismatch remains. Likewise the bankers who originally made the loans may well have moved on, and not suffer the consequences of bad decisions.)
   
   But straight banking is now a small fraction of our financial system. The securities industry, which is what banks have morphed into, is huge, and with a regulatory system that emphasizes the letter of the (common) law, we seem unable to restrain the growth of "shadow banks". When money is "tight" shadow banks and securities firms have a harder time raising funds, and the yield curve can work against them. But it's like a case of AIDS, with a combination of basic regulation and normal monetary policy we can restrain its ability to cause illness but to date we can't eliminate HIV entirely. Lapses in medication lead to bad outcomes.

So perhaps medical analogies have their use. There is however no (simple?) diagnose-and-treat lesson to be had. Rather, it is that the economy, like the human body, is very complicated, and textbooks will only get you so far. Medicine remains rooted in apprenticeship. Economics must as well

Republicans and Federalism

Original post March 3, 2009 on "Autos and Economics" blog, moved here as part of reorganization of my blogs.
This has become a hot topic: for a related post see a Paul Krugman NYT op-ed on Texas.

One of the legacies of George Bush will be a n erosion of state's rights. There is much irony in that, because it is in direct contradiction to his self-proclaimed position of opposing the power of the Federal government in favor of those of these several States assembled.
First of course is his own push for an imperial presidency, that sits above both courts and legislature. Here we have had an administration that claimed to seek judges for our highest courts who would adhere to our founding father's faith as expressed in the Constitution. But not in practice. Who is the arbiter of what is legal? The presidency. What is the role of the legislator? To do his bidding, and if not, to be overridden in signing statements.
Second were a series of policies that intruded into historic state powers, over education, over law enforcement and in other areas. This is hardly new, and not necessarily inappropriate: there is no particular reason that the range of contemporary issues will line up neatly with the divisions of locality and state that prevailed in the past, much less the distant past. However, a number of such policies, including in education, have not been accompanied by a commensurate transfer financial resources from the federal government. In other words, while on paper states had been delegated responsibility, from their perspective these were unfunded mandates to follow federal guidelines for tasks that as often as not had long been delegated to them. So the reality has been that in the name of states rights their powers have been abrogated by the federal government in a manner costly to their fisc.
Third and not yet apparent is the long-run impact of multiple bubbles. As long as real estate prices and retail sales boomed, grumbling did not translate opposition to the above changes. With 50 states and over 10,000 localities, priorities vary widely; organizing joint "voice" proves well-nigh impossible. This is the in line with the standard "tragedy of the commons," but the common result is that states and localities throughout the US are facing budgetary pressures unknown in memory – perhaps they were worse in the 1930s, but not in my memory. For all practical purposes they are unprecedented.
Here I am making a prediction, bolstered by years of casual observation as an economist rather than a close reading of developments in local public finance. I believe, however, that states and localities in hardest-hit regions will face bankruptcy before the current recession recedes, not the least of which will be California. In the meantime, the provision of basic services such as education and public safety is being pared to the bone, and beyond, weakening these systems for years to come. The only way to stave off collapse will be through a vast expansion of subventions from the federal government. This will represent a de facto transfer of power to Washington, unlike anything seen before, wrought out of the dregs of 8 years of Republican rule.
As an economist I have mixed feelings about this; I believe that today the US is primarily a national economy rather than a collection of local economies. We can see this in our personal mobility, in the growth of retailers that are national in scope, and in the multi-state (though not yet truly national) structure of our banking system. Having political subdivisions disjoint from the geography of our economy does not (always? every?) make sense. What the Republicans have done is to undermine the status quo from multiple directions. This seems not to have been a conscious process; there certainly was no vision of a new order. But it may already be too late to shore up that old infrastructure.
In any case, the irony remains that politicians mouthing the mantra of states rights have unleashed forces that in hindsight serve instead to increase the power to the central government.