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Bad Outcomes Lead to Bad Policy

December 18, 2011

Both in the current depression and the Great Depression, bad monetary policy lead to bad microeconomic policy, which worsened the initial outcome. As Keynes notes*, the common man does not understand how monetary policy. Perhaps only half of the population understands that inflation is caused by too much money, and fewer still understand how unemployment can be caused by contractionary monetary policy. They do understand that Congress can do things to help the economy, but they don’t understand what those things are. Thus, an inescapable logic is born:

1. Something must be done.
2. This is something.
3. Therefore, this must be done.

Well designed policies take time, time which a panicked people and legislature do not have. Projects dreamed up at the 11th hour will be far more wasteful and corrupt than those carefully laid out ahead of time. Also, all of the common economic fallacies and errors are brought into play when economic policy is done in a populist, emotional way. Trade is restricted, minimum wages raised, taxes on businesses increased, government debt levels increase, and new (poorly thought out) regulation is created. Every new policy is another albatross on the economy’s neck.

In the Great Depression, all the crazy policies eventually had to be ended in the face of war. Roosevelt could either focus on coming up with new economic policies or running the war. Fortunately, he chose to focus on the war. By the time Truman was in office, there was no more political demand for action, and so the economy recovered on its own. The economy does heal itself over time, as prices adjust and people get used to the new policies, but I do not know how long that will take.

*”There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
– Keynes, The Economic Consequences of the Peace, Chapter VI

Update:
Scott Sumner comments (before I wrote this article). In his mental model, if we get good outcomes, resistence to abolishing bad policies will evaporate, allowing us to get more and more good policies.
Caplan on the Idea Trap.

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