Government Etiology (post #2 of 3)

The blog, The Conspiracy to Keep You Poor and Stupid by Donald Luskin, published a post titled, “A Marriage on the Rocks” written by Steven Hales. Mr. Hales and I have corresponded on this issue and he has given me permission to post our correspondence along with my comments. I have titled these posts as “Government Etiology” (the initial correspondence) followed by the “Government Regulation” post which combines my comments with Steven’s “A Marriage on the Rocks” article. 

In this initial correspondence Mr. Hale crafts a very cogent explanation of the rationale for the development of government and by extension, regulation. I offer my comments as to how the origination of our government differs from its current manifestation.

Government Etiology

Steven Hales:    If the main purpose of government is to provide a framework for the free exchange of goods, services and ideas, to provide for protection of property rights as well as protect the citizenry then you would say that government has already gone too far.  But what has driven it to this metaphorical cliff?  I would say that it is increasing complexity in our relations with each other (here I am referring to all relations from individuals to companies to government).  This necessitates a more nuanced or complex response from our government, something that is sorely lacking in our current administration and in the last administration because the nature of the increasing complexity is not well understood.  

RedSt8r:               First, I disagree with the premise that “increasing complexity in our relations with each other” drives the government regulatory bureaucracy. It is the other way around. Government complexity drives our relations. Regulators craft rules for our “free exchange of goods, services and ideas” and each year they add to those rules. I believe that is because once a set of rules are crafted what else would the regulators do? As carpenters hammer and saw, regulators craft rules and re-craft rules and craft rules for crafting rules.

Second, government is fundamentally incapable of “a nuanced or complex response” because they are incapable of crafting a rule to encompass nuance. No rule no response. 

Steven Hales:    To look at complexity let’s take a look at the business cycle and how government responds and has responded.  Since the business cycle exists and is subject to some unknown periodicity we have developed several responses to smooth out the ill effects of this cycle.  One of these tools is unemployment insurance.  Workers and employers contribute to an unemployment insurance fund which is then disbursed to those workers who lose their jobs and are searching for new ones.  Now this fund is used even when the business cycle is in a positive phase but its real benefit is to support aggregate demand in a general economic downturn.

RedSt8r:               Okay so far. 

 Steven Hales:   But you would say this is hardly a complexity more a mundane feature of economic activity present since antiquity.  But our current recessions are usually global in nature and have triggers that can arise in the most curious of places.  When, in 2007, the pricing of certain real estate financial instruments was not possible the mortgage market froze.  This was the beginning of the recession and its cause had barely been recognized.  Who would think that the relatively small sub-prime market would trigger a financial collapse?  This took place in an environment of lax regulation and direct government mandate of increased home ownership.  The problem wasn’t too much regulation but too little.  Government had deviated from its primary purposes.  Restoring regulation to its proper role is what we are now trying to accomplish.

RedSt8r:               It is an arguable proposition whether it was too little or too much regulation. One should differentiate between regulations (rules) and regulators (government officials charged with enforcing regulations). We have plenty of regulations but the enforcement was lacking. Many of us attribute that lack of enforcement to other government officials such as legislators and the Fed who actively proscribed the necessary enforcement. Government has indeed deviated from its primary purpose but that has been the case for at least two decades. Restoring regulations is incorrect. It should be restoring regulatory enforcement of regulations. Any restoration of regulatory enforcement will be met with fierce resistance from the regulated. 

Steven Hales:    The other problem is that the government had transferred market risk onto itself (implicitly through the GSEs) in the midst of an economic boom and ironically became the catalyst for the boom.  Risk transference is something the government should only undertake in an economic downturn.  The FED being the lender of last resort, deficit spending to spur private business activity are all tools of risk transfer when the private economy is risk averse.

RedSt8r:               Au contraire. Government should never be in the position of holding or receiving market risk. Government stepping in to contain the economic problems while simultaneously allowing market participants to fail and fail big is quite different from preventing private failure in the first instance.

Fed lending – quantitative easing or QE – is exactly the wrong prescription at almost any time. The Fed can create low interest rates to ease the cost of borrowing but this is vastly different from the Fed doing the lending directly. Transfer of risk to the government has paradoxically increased the risk to the taxpayer and created massive moral hazard to boot. The Fed should only be the “lender of last resort” when it steps in to prop up the banking system by providing costly liquidity and taking quality assets as security. This time around the Fed has provided cheap liquidity and taken the lowest quality assets. Even worse the Fed has stepped outside the normal bank arena to provide this liquidity and QE to all manner of financial purveyors. 

Steven Hales:    Today, this process of risk transference has exceeded its usefulness because it is becoming increasingly difficult to unwind this risk taking by government and in the process government has accelerated the claims on future output by engaging in unwise and ill planned investments.  Here I am referring to the Bush and Obama stimulus bills.  Ex-Tarp these bills were pure deficit spending totaling some $1.5 trillion.  The debt service of this spending is itself financed and the problem increases through compounding.  This process will claim an increasing share of federal revenues.

RedSt8r:               While not accepting the validity of government risk transfer I concur that the deficit spending has not cured anything but has made a bad situation seriously worse. 

Steven Hales:    Because the nature of the recession was little understood in its increasing complexity and the government response has likely compounded the problem and extended the length of the recession but lessened its depth, it is unlikely that government will now respond correctly and it is left to the private economy to grow our way out of the mess.  But economic growth will have to be extraordinary to be effective.

RedSt8r:               Here I disagree that the “nature of the recession was little understood”. But I agree that the private economy must “grow our way out of the mess”. After all it is the private sector that supports and feeds the public sector not the other way around.

My disagreement regarding the understanding of the nature of the recession is conditioned on the response of the government. Unfortunately I believe their response was crafted not to contain the situation but to support the financial entities with which government was most familiar with and most comfortable with. Yes, this is a conspiracy theory of sorts. But look at their response. Bailing out the favored financial institutions (but not all) was done ad hoc as the first response. There was and still is no public recognition that the issue was always solvency and not liquidity. But to accept solvency as the issue puts the favored financial institutions in a position of bankruptcy and our regulators will not do this. 

Steven Hales:    How might we persuade government to now get out of the way and focus on its proper role?  First we must recognize that the size of government today is not just a result of ideological driven takings but really a response to uncertainty. And that uncertainty derives from complexity of relations.  We are part of a global economy where whole towns can be devastated overnight; where financial capital flows to where returns are greatest.  National currencies are buffeted about by global trade; where the gains from trade are blurred by protectionist rhetoric; where political movements can arise from an on-air rant; where recessions can be caused by falsely enabling the poorest of the aspirational. 

RedSt8r:               We cannot persuade government to get out of the way. We can only force them. I vehemently disagree with the idea that government complexity is a benign outcome of supposed complex activity. Government complexity is a conscious design intent to ensure its survival and growth. None of the listed examples – towns devastated overnight, currency movement, capital flows, etc. – are new. All have been present for decades. On-air rants are the technological equivalent of pamphleteers and rabble rousers. Again, not new. 

Steven Hales:    Government must not be moved to over-regulate or to improperly reduce uncertainty it must move carefully and deliberately it must cease the destructive rhetoric directed at our best and brightest.  It must not be swayed by interest groups that little understand what they promote.  It must embrace the possible, the productive, the most prudent use of its revenues.  It must respond to complexity not by old responses of ossified regulation or mandates on behavior.  It must above all be smart.  It must understand that innovation cannot be directed or taxed into existence that it arises where there are incentives.  For it will only be through innovation and technology that many of the problems we see today will be solved.  If we could promote an innovation focused government we would have a government that increased incentives not for pet projects or social goals but pure innovation that reduces the work required to get something done.  But this only arises when government first protects property rights, fosters an environment of free exchange and protects it citizens.  Is this too much to ask?

RedSt8r:               Government will continue to craft rules and regulators will continue to enforce the rules. It cannot be “smart” as you suggest for the simple reason that today government is akin to any physical organism. It will grow (tax, regulate) to survive and thrive. Government has no interest in innovation only its own survival and gain. Asking government to simplify itself is like asking a human to eat less. Might be helpful, beneficial even, but not going to happen. Force is required. Not necessarily physical force. It could be force by ballot or by quiet revolution. But force it must be.

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