What should governments do to combat recessions? In the United States, before the Great Depression of the 1930s, the answer was “very little.” Of course, the federal government was much smaller then compared to the size of the private sector, so its options were limited.

The Depression changed all of that. In the mid-1930s, the British economist John Maynard Keynes developed a new paradigm: “The economy” was reified; that is, it was regarded as an entity in itself, sort of like a mechanism that could be repaired and fine-tuned, thereby “smoothing out” the booms and busts of the business cycle. Keynes shifted the focus of attention from individual economic behavior (“microeconomics”) to collective statistics such as “aggregate demand,” “price levels,” “unemployment rates,” etc. “Macroeconomics” was born.

The two primary “tools” of macroeconomic mechanics are fiscal and monetary policy. In the decades immediately after the Keynesian revolution, governments embraced “contracyclical” fiscal policy—responding to recessions by increasing deficit spending.

After the horrible stagflation (simultaneous economic sluggishness, high unemployment, and high inflation) of the 1970s, monetarism—Milton Friedman’s theory that monetary policy was of primary importance in keeping “the economy” on a steady growth path—gained popularity.

Fast forward to today, and we find our economy mired in its worst downturn since the Great Depression. Fiscal and monetary policies have not prevented the current mess, and in fact have produced it (detailing how would require a book). What macroeconomic policy is government employing?

Chairman Ben Bernanke’s Federal Reserve has decided on an easy-money policy, holding short-term interest rates near zero percent, doubling the monetary base, and continually purchasing all sorts of dubious financial assets from banks and government agencies.

Presidents Bush and Obama both pushed “stimulus” spending bills through Congress. Keynesian deficit-spending is still being used as a macroeconomic tool against recession (as usual, without notable success). Where do we go from here?

One macroeconomic viewpoint currently gaining traction is Richard Koo’s “balance sheet recession” theory. Dr. Koo, chief economist of Nomura Research Institute in Japan, sees today’s post-bubble U.S. economic predicament as being similar to Japan’s post-bubble situation in the early ‘90s: Because banks’ balance sheets are so weak, bank lending is declining, despite the Fed supplying massive amounts of reserves. The Fed is “pushing on a string”—i.e, powerless to compel banks to issue loans or customers from borrowing funds.

American banks are emulating the Japanese strategy: borrow from the central bank at miniscule interest rates and purchase safe, higher-yielding longer-term government bonds, slowly repairing their balance sheets with this risk-free interest-rate spread. Because this mending process takes many years, Koo asserts that Uncle Sam should continue running large deficits—in other words, use fiscal policy to compensate for the lack of lending, thereby preventing a deflationary collapse featuring a chain reaction of bank failures and debt liquidation. It worked in Japan and can work here, too, he maintains.

Prominent economic commentators like Martin Wolf and Paul Krugman have jumped on this bandwagon. They agree that the United States should not reduce fiscal deficits until a recovery is firmly established. Unfortunately, nobody is asking the crucial question: Are the costs of such a policy worth it?

True, Japan has avoided a financial wipeout and the sweeping economic adjustments and restructuring that would have followed. The price has been nearly two decades of economic stagnation. The Japanese economy remains subdued, and is now saddled with an accumulated debt of 200 percent of GDP, a burden that will retard economic activity for additional decades unless an economic cataclysm forces the needed restructuring. Also, because Japanese banks have financed governments instead of private firms, Japan’s public sector has grown at the expense of its private sector, another formula for economic stagnation.

In short, Japan has won the battle against a deflationary collapse, but lost the war for economic prosperity. Do we want to follow Japan down the dreary road of decades-long stagnation?

Unfortunately, there is no pain-free alternative. Decades of government intervention have prevented needed adjustments, resulting in a gargantuan, rotten financial house of cards looming over us. Whenever the inevitable collapse happens, GDP will plunge. It will be like the economy has been hit by a financial neutron bomb. The problem is, the longer we wait for this to happen, the larger and more painful the collapse.

What is the “right” macroeconomic policy? I reject the macroeconomic premise that the economy is a mechanism that can be mastered by government. Macroeconomics is an epistemological absurdity undergirding economic fallacies used to justify political frauds.

The right public policy is summarized in one word: Freedom. Abolish the central bank, scrap legal tender laws, and limit government to its original constitutional function of protecting individual rights.

If, by some miracle, free markets were allowed to function, we would pass through a couple of years of wrenching adjustments and economic hell that would produce a solid, economically rational foundation leading to a prolonged period of strong, sustainable economic growth. But then our children then would inherit a much more economically healthy future.

There is no economic pain-free utopia, but free markets will optimize wealth creation and minimize the jarring disruptions of inflation, deflation, recession, booms and busts that government intervention invariably produces.

V & V