Obamanomics: Lessons for the President-Elect

Wall Street's problems have captured the attention of Congress, the White House and the media. But ordinary folks are wondering if anyone is paying attention to them. A look at how Americans are coping with the economic crisis.

Barack Obama's stunning election victory was a compelling mandate for change, especially in regard to the way the economy has been run. People's lives and livelihoods have been deeply affected by the financial crisis, and Americans are justifiably worried and angry. To set the economy on the right path again, new checks and balances to regulate our financial system are already being discussed and explored. But even as we start to search for new solutions, we have already come to a perilous fork in the road.

In one direction lies a backlash against capitalism. Some blame the crisis on excesses borne of laissez-faire policies that created wealth for a few at the expense of many. Given the current crisis, that sentiment may be understandable. But it is dangerous.

History teaches us that this backlash generates a populist push that can easily morph into economic policies that turn away from free trade, tax high-income earners, impede markets in the name of redistributing income, and pander to special-interest groups that cost a lot while carrying few benefits. The result can be large and long-lived effects that depress economic activity, sometimes for decades.

A lately, oft-cited case in point: the Great Depression. The 1930s brought forward an unprecedented increase in government economic intervention, and policies that substantially distorted markets and reduced economic well-being. Some of these interventions, such as the National Industrial Recovery Act and the National Labor Relations Act, gave enormous bargaining power to labor. Many economists have concluded that these policies were primarily responsible for keeping unemployment well above 10 percent until World War II, when labor's bargaining strength was reduced by the National War Labor Board.

Other New Deal policies explicitly focused on benefiting particular industries at the expense of others. Agriculture is a potent example.

Subsidies to agriculture increased substantially in 1933 with the goal of increasing the incomes of farmers. They continue to this day. Of course, farm incomes have changed substantially since the 1930s. Today, farm subsidies exceed $25 billion per year—most of which is paid to large commercial producers, some of whom have incomes in excess of $200,000 per year and net worths of nearly $2 million. These subsidies cost households about $350 per year in higher food bills.

Fannie Mae, the government-sponsored enterprise that was a major contributor to our current crisis, was the product of the New Deal, when it was determined that the government should provide an intermediary to make sure housing loans would be made. Fannie Mae might have been useful in the 1930s, but there are no convincing arguments that it was necessary after that.

Another example: Britain in the 1940s faced the daunting task of paying for a war against Germany. John Maynard Keynes was determined to have the Treasury finance as much of the expenditure as possible by levying taxes on wealthy households—both to fund the war and to redistribute income. To this end, Keynes strong-armed the Treasury to raise taxes on capital income to close to 100 percent during the war; high capital income tax rates persisted though the 1960s. The result was very low savings and investment, and very little economic growth. Economic growth and investment rose once these tax rates declined.

But there's another road we can take and it's lined with more opportunity than obstacles. History provides compelling examples of crises that led to policies that removed distortions, limited the role of special interests, and stimulated long-term expansion in the economy.

India, for example, was faced with a major crisis in 1990-1991. After four decades of pursuing a strategy of import substitution where the state played a central role in the economy, India found itself in the throes of a balance-of-payments crisis. In response they undertook radical reforms that removed controls on industrial investment and on imports, reduced import tariffs, and opened the country to foreign capital. The result has been nearly 20 years of astonishing growth that has lifted several hundred million people out of poverty.

In the early 1980s, Chile was faced with its own financial turmoil. Rather than continuing to subsidize politically connected borrowers and rely on significant state involvement in its banking system, Chile privatized state-owned banks and streamlined bankruptcy proceedings, which led to the exit of many inefficient producers. The result was a major increase in lending from private rather than state-owned banks, and an explosion in productivity as investment funds were allocated to the most productive enterprises. Chile is the only country in Latin America that has consistently grown faster than the United States over the last 25 years.

The lesson here: be careful what you wish for. There is a familiar urge to restrict those who got us into this mess, but regulation is a nasty business—nasty because the law of unintended consequences is always there to show us how we got it wrong.

The danger we face at this fork in the road is the conventional wisdom that associates more regulation with better regulation and more restrictive policies with less risk. History teaches us that the opposite is usually true and that the costs of getting it wrong can last for decades.