The perils of government overreach

In the government's rush to stabilise the financial system, get the US economy moving again, craft bailouts for institutions and entire sectors of the economy, and re-craft bailouts that aren't doing the trick, the voices of limited government have been all but silenced.

In Washington, the GOP has been shamed into submission. It's not that Republicans don't see a role for the government in the economy, says Karl Rove, former adviser to President George W Bush, in his weekly op-ed column in the Wall Street Journal. It's just that they don't see the same role as the one envisioned by President Barack Obama.

That role, laid out in his first budget last week, will be larger than at any time since 1945. Government spending is projected to soar to 27.7 per cent of gross domestic product in fiscal 2009, which ends in September, according to the White House Office of Management and Budget.

That compares with an average of 20.4 per cent over the last 30 years.

In an era when we've all become interventionists - when doing something, anything, is preferable to doing nothing and risking being blamed for any outcome - it's good to hear a few voices pointing to the danger of government overreach.

Historical evidence suggests that "bad government policies are responsible for causing great depressions", write Timothy J Kehoe, professor of economics at the University of Minnesota, and Gonzalo Fernandez de Cordoba, professor of economics at Universidad de Salamanca in Salamanca, Spain, in The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?

It turns out the source of the shock, be it internal or external, that triggers a depression "is less important than the reaction to the shock by the economy and, in particular, the government", the economists write.

Before you dismiss Kehoe's views as those of a card-carrying libertarian, consider that he was trained as a Keynesian, is a "lifelong Democrat, voted for Obama", and believes in universal healthcare, he says in a telephone interview.

That said, he's opposed to rewarding people who made bad investments. "The TARP money disappeared; it was scandalous," Kehoe says, referring to the Treasury's Troubled Asset Relief Programme. "It went to people who made bad investments to try to pull them out."

The economists' findings in their February 2009 paper are based on a study Kehoe and Edward Prescott, recipient of the 2004 Nobel Prize in economics, have been running at the Minneapolis Fed, analyzing depressions in North America and Western Europe in the 1930s, Latin American in the 1980s and isolated examples elsewhere.

They differentiate good outcomes to financial crises (Chile, Finland) from bad outcomes (Mexico, Japan) and find productivity plays an important role.

"All these depressions are associated with bad policies that depress the efficiency of production," Prescott says in a phone interview.

"The focus should be on productivity. History provides no support for stimulus."

The current crisis and recession may be different than previous ones in terms of their size and scope, but that does nothing to contradict Kehoe's belief that the financial system needs to be "cleaned out".

In the early 1980s, Chile took control of ailing banks, liquidated the insolvent ones and re-privatised the solvent ones. "The short-term costs of the crisis and the reform in Chile were severe," Kehoe writes.

By 1984, the economy had started to grow. And Chile has been the fastest-growing country in Latin America since then.

It's worth the cost to sort things out as quickly as possible, he says. "If you postpone short-term pain, you end up with long-term pain," which is what happened in Mexico and Japan.