Rand Paul and President Obama. One a libertarian, the other a left-liberal progressive. But they apparently have at least one thing in common: a belief that markets are fragile things. Both subscribe to the view that a speculative bubble caused the Great Recession. As Obama said in his recent Knox College speech, “But by the time I took office in 2009, the [housing] bubble had burst, costing millions of Americans their jobs, their homes, and their savings.” (Actually, it was passive Fed tightening in 2008, in a replay of the Fed’s Great Depression error, that turned a possible modest downturn into the Great Recession.)
That comment led economist Brad DeLong to call Obama a “neo-Austrian” or accidental Hayekian since Austrian economics — which can count Paul as a loyal devotee — contends the business cycle is driven by speculative excess leading to economic bubbles. Markets break down. Markets fail. Richmond Fed economist Robert Hetzel calls this the “market disorder” view of how economies work and the role government should play:
Adherents of the market-disorder view believe that sharp swings in expectations about the future from unfounded optimism to unfounded pessimism overwhelm the ability of offsetting changes in the real interest rate to stabilize economic activity. … The view that financial fragility produces real instability is associated with the belief that markets are inherently unstable. From this view, it follows that economic stability requires the regulation of markets through government intervention.
Where Friedrich Hayek and JM Keynes, Paul and Obama, disagree is what should happen when markets fail. Keynes-Obama argue for fiscal stimulus, Hayek-Paul for liquidation — “Let the banks fail!” — to purge the rot out of the system. As Milton Friedman said of the Austrian approach:
I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.
Milton Friedman (and Adam Smith) had a different view of markets from Keynes/Hayek/Obama/Paul, that they were sturdy and self-regulating if the price system was allowed to work. Again, Hetzel frames the two views:
Do fluctuations in the business cycle originate in instability in financial markets due to excessive risk taking? Alternatively, do they originate in instability in money creation due to the failure of central banks to allow the price system to work? … The monetary disorder view is that the price system works well to equilibriate the economy provided that money creation and destruction do not prevent interest rates from adjusting. There is no inevitable movement from boom to bust
Hetzel and today’s “market monetarists” want the Fed to follow a monetary rule that provides for a stable nominal anchor — like nominal GDP — and allows market forces to determine the real interest rate and other real variables amid a stable monetary backdrop. Indeed, economist Scott Sumner has proposed letting Fed policymakers determine a goal of monetary policy, such as stable growth in nominal GDP, and then having markets, via a futures market, “implement the policy by adjusting the monetary base until it’s at a level where the expected 12-month forward level of NGDP equals the policy goal.” Basically, market-driven central banking.
Instead, the Fed currently operates with discretion to deal with supposed market failures and, as Friedman wrote in Free to Choose, “continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality the government is today is the major source of economic instability.” Paul sort of gets this, I guess, but instead of arguing for “ending the Fed” he should argue for “ending the Fed as we know it” and embrace a market-driven monetary policy as proposed by Sumner. And begin to trust markets.