Dealing with Boom and Bust

Posted on March 28, 2012 at 11:18 am,

This is the next in our series of posts critiquing Wayne Grudem’s book Politics According to the Bible. Today we’re finishing up the chapter on economics by looking at the issue of recessions, and how best to get out of them.

This section starts by talking about the state of the US economy around the time President Obama took office. At that point, the economy was crashing because of a financial crisis. Banks had lent lots of money in mortgages to people who couldn’t afford to repay them. They had then packaged up the loans and sold them (or, technically, the income from them) on to other financial institutions. These investments had been certified as top quality by the credit ratings agencies. However, enough people had now started to default that that rating was clearly wrong. However, because it was impossible to tell which set of packaged loans contained the risky investments, that the entire system was in crisis. If nothing had been done, then the financial system would have completely collapsed, and the rest of the economy with it. Grudem doesn’t mention the selling on of the loans, but it’s a detail worth bearing in mind.

Grudem then gives a brief introduction to the two different approaches to dealing with recessions in a capitalist economy. The first is Keynsianism. This view recommends increasing government spending in order to keep the economy going. The second view, which Grudem calls the “free market” approach (but which is more commonly called monetarism) is to cut taxes and trust that the free market will sort everything out.

He notes that Obama’s approach was Keynsian, and claims that the spending programs in question were far beyond anything that any government has ever spent in the history of the world. Although this is probably true in terms of the absolute number of dollars spent, it may not be the case in real terms (i.e. adjusting for inflation), or in relative terms (measuring as a proportion of the nation’s economy). I haven’t done the sums, but I suspect that World War Two was significantly more expensive in both real terms and proportional terms. Either way, the US national debt increased significantly.

Grudem has two strands of criticism of this approach. The first is the question of where the money comes from. If it’s debt, he wonders what happens if the creditors see increasing deficits and then demand a higher interest rate. In such a case, he imagines that such a situation would require vastly higher tax rates to ensure the debt is repaid (even though he believes that lower tax rates bring in more revenue). He also worries that printing more money means that you are increasing the size of the economy without bringing in any extra value, hence causing inflation.

His second strand of criticism is that he believes that the specific programs funded by the stimulus are designed to promote the Democrat party’s ideal of society, rather than economic growth. He repeats his belief that the private sector is always better than the government when it comes to growing the economy, and that a permanent decrease in tax revenues would have been a better solution.

The Benefit of Hindsight

Because I’m writing this a couple of years later than Grudem, I have an unfair advantage – I can see some of the results of the policies that both the US and other nations have pursued to deal with this economic crisis. So let’s look at his analysis and see how well it has fared.

Governments around the world have taken different approaches to the financial crisis. The Western nations that have gone furthest down Grudem’s austerity route are Greece and Portugal. If you’ve been following economic news, you’ll be aware that their constantly increasing financial problems are dragging the Eurozone down with them. This has lead to some major demands from their creditors and several bail-outs. The US, which has taken a much more Keynsian approach than other countries, has weathered the storm a lot better. The main problems with the nation’s creditors have come not as a result of stimulus spending, but by the threat of the (Republican-controlled) congress refusing to raise the debt ceiling (the total amount borrowed), which would have amounted to a de facto default.

When it comes to the question of creating money out of nothing and causing inflation, this is arguably what the financial institutions whose actions caused the crash had been doing. Their growth had been a major part of the world economy (here in the UK, it was the main driver of our national economic growth). Most of this growth was as illusory as any growth caused by governments doing “quantitative easing”. It’s worth nothing here that Grudem blames the crisis on 1070s legislation which made American financial institutions lend in poor non-white neighbourhoods, rather than on the banks who repackaged those loans as dodgy securities, or on the relaxation of regulation that allowed them to do so.

On the question of what the purpose of the US government’s stimulus plan was, Grudem is – once again – guilty of drawing a dodgy picture of his opponents’ motivations. The initial spending was simply to keep the financial system from collapsing. Subsequent spending included projects that would create jobs in the middle of rising unemployment, and bailing out companies like General Motors (and, therefore, keeping an awful lot of people in jobs). Gordon Brown’s stimulus package in the UK was broadly similar. The aim was to keep the economy afloat, and to prevent as many job losses as possible.

As for the question of which approach (government spending or tax cuts) works better, it’s worth noting that the financial crisis is the worst since the Wall Street Crash in 1929, and the decade of depression which followed it. Whilst economics rarely provides provable results (it’s very difficult to isolate the effect of any one variable), it is generally accepted that the Depression was ended by massive government spending. Initially this was the likes of Roosevelt’s New Deal program, but eventually it was the massive spending on waging World War Two. Earlier responses to the Depression had been much more along the lines of monetarism, and are generally believed to have had little effect.

Whilst Grudem believes that lowering taxes (and, as a result, putting people in public sector jobs out of work) would lead to more jobs being created than were destroyed, there is no evidence to support this assertion. Since the 2010 election, this is the approach that has been tried in the UK. Unemployment has not fallen. This suggests that, whilst Grudem’s approach may be the better one in some circumstances, it would not have been a very effective approach in the current crisis.

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