We're all to blame for the financial crisis, and we're all trying to create another

What was the root cause of the financial crisis? I normally answer this by looking at the knowledge and incentive problems within central banks, explaining how an excess of easy money produces an Austrian-style trade cycle. One of the most intellectually satisfying parts of my job is witnessing these insights shift from being viewed as outdated and "extreme", to part of the conventional wisdom. In 2006 I was conscious that a lot of the topics I fed students (e.g. the Great Depression, boom/bust cycles, asset bubbles) appeared to be irrelevant. Now, there's a plethora of readings, videos and commentary from across the political spectrum going back to the same issues.

But whilst I'd maintain that credit creation is the root cause, when I have the ear of those in power (or those close to power, or those close to those in power, or those close to those close to being in power), I tell them not to focus attention on monetary policy. In actual fact, there is a more fundamental problem that should be addressed first.

Below is a diagram I show in all my courses, and it comes from Pete Boettke:

The first step stems from Buchanan and Wagner's critique of Keynesian-style aggregate demand management. Recourse to political economy undermines the economic rationale for fiscal policy - whilst *in theory* it may be desirable for governments to "smooth the cycle", *in practice* they face asymmetric incentives. It is politically popular to say "we'll spend money to boost the economy", but not "we'll repay the debt". (Let's ignore other Austrian criticisms such as the heterogeneity of capital, subjectivism of preferences and dispersed nature of knowledge). Consequently we expect permanent budget deficits - something that seems well born out by history.

Given that budget deficits are the norm, the question is what to do about them when they get so far out of control financial markets (i.e. regulators) insist discipline? There's only two obvious options: (i) raise taxes; (ii) reduce government spending (I'll ignore the sale of government assets). If you look at this Economist/YouGov poll, you'll see that:

cutting spending is a more popular approach than raising taxes, by a margin of 62% to 5%.

This is a pretty whopping margin! So given this overwhelming preference for spending cuts, what would people like to cut? Here's the results:

So if you were a politician, what would you do? The only area that more than 1/3rd of the population would like to be cut is "foreign aid" - possible the only area that liberal economists would say is under funded! One problem is the methodology employed. As Jeremy Horpedahl has pointed out before (I can't find a link) people are always going to make incompatible demands if questions are framed in such a way that allows this. But I'm sure this is reflective of genuine "damned if you do, damned if you don't" behaviour by the voting public.

Faced with this, the only real way to deal with the deficit is to make pledges not to raise taxes, to maintain government spending, and opt for the hidden tax: inflation.

The inevitable way out of this straight jacket is to keep printing money, devalue the pound, and postpone the crisis for as long as possible. As we witnessed in 2007/08 when the economy expands beyond it's productive capabilities, a bust is inevitable (and CPI might not be the best way to see it coming). Let's be clear - we are going down the same path again, and the root of it all is the level of public debt. But you don't have to watch many interviews with the general public (or indeed survey data) to see why it's inevitable.

As a student of Buchanan (sort of), I'm tempted to think of constitutional rules that would attempt to impose a ceiling on the public debt, the budget deficit, and perhaps even government spending. As a student of economic history, I have little confidence that such measures could be created, let alone enforced. Pete Boettke's "old adage" is the most important mental model to think through the current debate about economic reforms in the UK. It shoes why we're all screwed, and that we're all to blame.

Update: The Economist

A striking trend emerges. Many voters agree strongly with each of the original propositions in their pure form. But, when the downsides of those policies are pointed out to them, support drops off sharply. The fall is particularly big when it comes to kitting out British soldiers with better equipment: 83% of respondents agreed strongly with the general principle, but only 46% once it was suggested that, other things being equal, more guns abroad would mean less butter at home.

Also see their charts.

Comments

[Business Week MBA]

I didn't think such a great points now...

[Mohammad Keyhani]

"We're all to blame" is something you hear a lot. I wrote about it in an essay:
You can make a case that it is the fault of “the system” and you shouldn’t be singled out. An argument can be made that the harmful consequence was the result of a chain of events to which you or your organization may have contributed only little, and even that is ambiguous. All others responsible in that chain of events can probably claim the same thing and so ultimate responsibility will be diluted and no one takes the blame. Everybody agrees that “we are all to blame” but in fact no one is really held accountable...

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