A Pendulum Swing Toward Austerity

http://www.nytimes.com/2010/06/27/business/economy/27view.html

A Pendulum Swing Toward Austerity
TYLER COWEN
June 25, 2010

“THE ROAD TO SERFDOM,” the critique of socialism written 65 years ago by the Nobel laureate economist Friedrich von Hayek, was recently No. 1 in nonfiction sales at Amazon.com.

Many people, including the Fox News commentator Glenn Beck, have contended that growth of government power has, indeed, set us on such a road today. But the reality looks different. In many respects, the expansionary phase of big government is coming to an end, and quickly.

In the last few years, we have seen — for better or worse — huge financial bailouts, a $787 billion stimulus plan and legislation for near-universal health insurance coverage. But the policy mood in Washington is now much more modest: no second major stimulus is forthcoming and, in the environmental arena, a cap-and-trade system for greenhouse gas emissions is unlikely to move forward.

The financial regulation bill will most likely pass, but it won’t fundamentally restructure the American economy. For instance, there is no longer talk of breaking up the big financial institutions, and Simon Johnson, the M.I.T. economist, has described the legislation as a failure.

To the extent that the bill limits proprietary trading by American banks — through the so-called Volcker amendment, named for the former Federal Reserve chairman — loopholes may enable banks to keep trading through asset management companies.

The most extreme outcome would be that more financial market trading is pushed out of banks and into hedge funds and other bank competitors. That would matter a lot for bank profits, but American capital markets would perform essentially the same functions as before. The bill we’re getting may be a mere hodgepodge, and that is after the biggest financial crisis since the Great Depression.

If any financial policy idea is taking a major place on the American and global stages, it is fiscal austerity. It is not that fiscal conservatives have won a grand battle of ideas, but rather that governments realize that the bills are coming due. In the United States, we face rising health care costs and pension problems in state governments, with no clear long-run solution for bringing the books into balance.

That makes responsible politicians reluctant to undertake major new commitments. At the very least, they embrace the rhetoric of fiscal conservatism, even when actual progress toward the ideal is slow.

In short, it’s not that ideas of government interventionism and free markets are fighting a titanic intellectual struggle. The reality is more mundane. The ascendancy of one view often creates the conditions for an economic counterreaction.

We’ve seen such cyclical trends before. During the 1980s and 1990s, history seemed to be on the side of freer markets. Communism staged a mass retreat, China and India embraced economic growth and a wide range of governments adopted privatization. The United States cut marginal tax rates and the Clinton administration promoted free trade and welfare reform.

Eventually, things started to go wrong, in part because investors developed too much self-confidence and became complacent about systemic risk. Early cracks in the edifice appeared in the 1990s, during the Mexican and Asian financial crises, but the bigger, broader explosion of 2007 revealed a badly overextended world economy, which led to bailouts. The weak economy brought victory for the Democrats in 2008, which in turn enabled passage of a health care overhaul.

Now the pendulum is swinging back. The economy will now likely make Congress much more Republican, as voters overreact to whatever is not working at the moment.

The unfolding of the financial crisis has also changed the public’s sense of where change is needed, both in the United States and Europe. The tragedies of 2008 were represented by Bear Stearns and Lehman Brothers — both private-sector institutions. In 2010, the financial crisis has spread to sovereign debt, with Greece as the most obvious example.

All of these developments are part of one broader story of overreach and complacency. Yet the 2008 crises were attached more directly to market institutions, while the 2010 crises are more closely linked to governments. Because politicians and voters are more influenced by the latest developments than by news from two or three years earlier, a cautious attitude toward public-sector spending has been further cemented.

While we can expect a larger public sector in America, the cause is mainly the aging of the population, and it will play itself out over the next 30 years with an increase in government transfer payments, mostly through Medicare. Furthermore, even Professor Hayek favored welfare spending and social insurance, so those programs will not alone bring us to serfdom.

DEMOCRACIES, like markets, have some self-correcting mechanisms, and we are now seeing those at work in the United States and many European countries. (Spain and Britain, for example, are pursuing fiscal austerity aggressively.)

The lessons are straightforward. First, to paraphrase the French moralist La Rochefoucauld, things are never as good, or as bad, as they seem. Second, the Obama reforms, like the Reagan revolution, are turning out to be radically incomplete, which should come as no surprise.

Finally, effective political ideas are those that can still do good in half-baked form. We have neglected this insight in designing financial reform, and it remains to be seen if we can apply it successfully to climate change.

And when it comes to the budget? Even if our real fiscal problems lie in the more distant future, it’s important to start worrying about them now, because we cannot count on a grand plan later to save the day.

Tyler Cowen is a professor of economics at George Mason University.

A version of this article appeared in print on June 27, 2010, on page BU5 of the New York edition.