The coronavirus is having a profound impact on our economies. Faced with economic downturns, governments have traditionally attempted to spur employment and restore economic health by propping up aggregate demand. Scholars differ on the track record of these interventions, yet all agree that governments, by stimulating demand, aim to provoke productive activity. Today, though, rather than trying to stimulate activity in the wake of the pandemic, governments are aiming to stop it. And at this task, everyone must agree, governments are performing splendidly.
Once the coronavirus is under control, restarting the economy faces many obstacles—especially social distancing. If we continue to remain at arms’ length from one another, we will hamper our natural “propensity to truck, barter, and exchange,” identified by Adam Smith as a key source of economic growth.
An even bigger impediment to renewed economic vigor, however, is the theory and practice of mainstream macroeconomics. The brainchild of John Maynard Keynes, modern macroeconomics focuses exclusively on aggregates, especially aggregate demand, and GDP. The economy is modeled on what economist Arnold Kling calls “a GDP factory,” or perhaps a machine. This machine produces stuff (GDP) and does so at peak efficiency when properly fueled. The fuel is aggregate demand—total spending—and it’s the job of government to ensure that the supply of fuel into this machine remains adequate.
If aggregate demand is too low, government primes the pump to ensure that the machine continues to produce as much stuff as possible, which will cause the machine to use as much labor as possible, thus increasing demand. If aggregate demand is excessive, government can reduce it, in order to prevent the machine from “overheating” with inflation. Economists debate the best way for government to keep aggregate demand at the right level. Keynesians believe that government should control aggregate demand through spending and taxation; monetarists favor central bank manipulation of the money supply.
It’s a foundational premise of macroeconomics that the only way in which this machine can malfunction is to be either under-fueled or over-fueled. Studying the details of the economy’s inner workings is the province of microeconomists. The best microeconomists have learned that the economy isn’t a machine. It is, instead, a complex and ever-evolving process of billions of human actions, each adjusting in real time to the signals—market prices—generated by the actions of consumers and entrepreneurs across the globe. Though the outcomes of this process can be tallied up in monetary terms and reported as GDP figures, to focus on only these aggregate outcomes is to miss the all-important details of the economic process.
Microeconomists understand that no one can engineer these details. If the economy’s institutional environment is sound—based on secure property and contract rights, rule of law, and free and open markets—market prices, profits, and losses will lead producers and consumers to act in ways that create prosperity. But for continuing prosperity, the market process must work freely. Entrepreneurs must be able to offer new products, workers empowered to accept and to reject job offers, consumers free to spend their incomes as they wish. And prices and wages must be free of government control and allowed to rise and fall as market conditions require.
Even if government control of aggregate demand is necessary for an economy to function even tolerably well—and we aren’t sure that it is—such control is clearly not sufficient. If entrepreneurs can’t introduce new products, if businesses are denied access to low-cost supplies, and if prices are prevented from changing, the market process falters. It produces fewer of the goods and services that are the stuff of our prosperity. The same conclusion pertains if workers are prevented from showing up at farms, factories, and offices, in which case no amount of extra aggregate demand will cause markets to produce more. To stop people on the ground from producing is to stop the process by which people, cooperating in markets, generate prosperity.
Standard macroeconomic thinking is today especially counterproductive. By maintaining the fiction that the economy is a simple GDP machine that will always work as long as it is sufficiently fueled with aggregate demand, attention is diverted away from the problems introduced into the market process by government interventions, as well as by major disruptors, such as Covid-19. The myth is maintained that if government keeps pumping funds into consumers’ hands and businesses’ coffers, all will be okay.
In Europe, for example, attention is focused on devising ways for governments to increase their public debt, without paying higher interest on it. But how will entrepreneurs, workers, and consumers return to their normal activities? Imagining how the provision of some services will work in the future (will movie theaters survive?) is a fascinating intellectual exercise, but one with little practical utility. Solutions will be found by entrepreneurs through trial and error, the same way that progress has always happened. What we need is not more fuel pumped into the GDP machine but assurances that its internal processes aren’t blocked. Governments have purposefully stopped the economy. To get it moving again, we eventually must remove obstacles that keep individuals from participating in market processes, both as consumers and as specialized producers.
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