Balancing Classical Ideas and Active Policies

New Classicals state that markets take any fiscal or monetary policy change into account thus making counter cyclical policies ineffective. They say that people’s models take all available information into account and price any policy changes into the market. The problem with totally ruling out the effectiveness of fiscal and monetary policy is that people’s expectations even in the aggregate are consistently wrong.

The wide variety of models people use, to make decisions in the economy and judge the effect of government policies, vary in their effectiveness(some doing better than others). The models that fail to predict the effects of government policies, and are continually modified over time may get better and better, never change fast enough to fully account for government changes in policy, and leave room for effective government policy changes. Additionally, the government has an informational advantage; it is impossible for the Government or the Fed to be completely open about their policies, even when they try(think Ben Bernanke at the Fed). At other times policy makers are intentionally opaque about the implementation of its policies in order to maintain the policies effectiveness (think Alan Greenspan at the Fed). Either way those who make policies have an informational advantage over the market.

The wide variety of models people have and the limited information available to the public leads to an incredible amount of error for those looking towards the future. The large error in people’s models allow for both fiscal and monetary policy to affect the economy.

If monetary and fiscal policies do have an effect on the economy why do people give the classical viewpoint any consideration? Often people point to the pro growth free market ideals of classical economics as reason to pay give the Classicals any time of day. While classical ideals may not produce the optimal outputs (as if a social planner were in charge of the economy),  the free markets will insure efficiency. Any entity that fails will fall out of the economy and be replaced by newer more efficient ones. Non Classicals promote free market ideals but consistently back down in the face of financial crisis. In the face of trying times policy makers are forced to balance the the severe short run, often gut wrenching, consequences, of watching the free markets run their course (with the classical promise of better long run growth) and jumping in to “save the economy from financial armageddon”.

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