Safeguards Against Economic Downturns

We’re not out of the financial crisis yet. Unemployment is at a historical high, and there is good reason to think we are in the middle of a “lost decade” — a period of low growth and high unemployment, the likes of which we haven’t seen in the modern history of this country. But if you’re like me, you’re already thinking ahead to the next crisis and how we might respond better than we did this time around.

Let us start with where we failed. The first lesson is that the regulatory framework did not work. An unregulated financial market combined with its players’ belief that its institutions will be bailed out encourages excessive risk-taking with catastrophic consequences. Some have argued that this means we shouldn’t bail out huge financial firms, but that is far easier said than done. When disaster strikes, the people call the government to action. It is unlikely we’ll ever see a government sit idly by while its citizens suffer. Additionally, it is unclear that the kind of financial innovations created over the past 30 years have led to greater growth and prosperity than the system we had before. The best way to deal with this moving forward is to establish a two-tier financial system: a regulated sector with a government guarantee and an unregulated sector where investors alone bear the brunt of profits and losses. 

The second lesson is that the politics of this country will likely prevent the government from ramping up purchases to offset the output gap, encourage confidence, and deter unemployment. It is also unclear whether those purchases can be made fast enough to prevent a nosedive. But there may be a way forward.

What we need is mechanisms that correct the business cycle — cutting taxes and raising spending — to be in place before we arrive at a crisis period. The less that countercyclical policy relies on politicians the better. Several of these “automatic stabilizers” are being floated around among academics, journalists, and politicians. One example is for the payroll tax to be tied to the unemployment rate. As the unemployment rate increases, the payroll tax would decrease to make hiring workers cheaper and more attractive for firms. There’s no reason other policies, such as the minimum wage, couldn’t function this way. Former President Bill Clinton recently proposed that we should amass a list of infrastructure projects designated as “shovel-ready” to authorize when a crisis hits.

Last, part of the reason the federal government wasn’t successful in stimulating the economy is that its increased purchases were offset by cutbacks in state and local government spending. More state aid could have deterred those losses if it was tied to the rate of economic growth.

While there is a large degree of consensus among economists and technocrats about how to prepare for and respond to the business cycle, there is great ignorance among the public and its representatives. Sadly, President Barack Obama has adopted the Republican mindset that because families are “tightening their belts,” the government ought to do the same. This combination of ignorance and political expediency is causing needless harm to the public. Though my faith in our politics is diminishing, we have learned a lot from this crisis. Now we need to make use of that knowledge. 

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