Economic activity tends to proceed in cycles Opens in new window. Sometimes, activity and job creation accelerate above the trend, sometimes they fall behind or decline.
Before the twentieth century, most considered this a natural fact of life, but from the 1930s onwards, many governments began promising to stabilize production and employment (this policy is sometimes called Keynesianism Opens in new window, after its chief protagonist, British Lord John Maynard Keynes).
The public policies proposed often became popular with electorates that did not yet see the limitations and long-term consequences of such an undertaking, such as rising public debt levels and sustained inflations that destroy the usefulness of money.
Nor was it initially evident that the artificial manipulation of economic activity by governments in the interest of stability benefited some sections of the community more than others and that the prevention of periodic ‘cleansing crises’ impeded long-term economic growth Opens in new window.
Critical voices pointed out that periodic economic crises were needed to adjust production and employment structures to new evolving conditions and to mop up costly, but redundant production facilities.
Counter-cyclical policy (demand management) is based on the assumption that policy makers know all the relevant variables in the open, modern economy Opens in new window.
Instead it has been discovered all too often that unintended side effects were triggered, including effects that made the business cycle Opens in new window more pronounced (procyclical effects) because lags between policy intervention and the movements of the economy were misjudged (that is, recognition, decision, implementation, and reaction lags).
In modern democracies, Keynesian policies Opens in new window have also introduced an inflationary bias: In recessions Opens in new window, it is popular for central banks to expand money supply and for finance ministers to cut taxes and increase public spending (running budget deficits).
It is much less popular and therefore rarer that corresponding restrictive measures are implemented when the economy booms.
As a result, there has been a long-term tendency to accumulate costly public-sector deficits, depriving private investors of some of the savings of capital that would serve long-term prosperity and job creation.
In addition, it needs to be recognized that living economies have always gone through business cycles. It is a natural rhythm, in which misjudged investments are written off.
When macroeconomic activism creates the impression that investors will be protected from such crises and that central banks will drive down and distort interest rates artificially, capital structures get increasingly out of line with evolving demand structures and undue entrepreneurial risk-taking is encouraged (Hayek, 1935; Burton, 1986; Mankiw et al., 1993).
We conclude that business cycles Opens in new window will always be a fact of life, but that the intensity of the cycle depends critically on the flexibility of the economy Opens in new window, that is, the intensity of competition.
Fiscal and monetary activism—even if politically popular in the short-term—rigidifies economic structures and therefore prejudices long-term economic growth and employment.The promise of stability has also expanded the role of government and restrictive controls, all too often resulting in limitations of economic freedom.
The alternative of fostering a competitive economy would have made producers and employers more alert and responsive to changes in economic circumstances and would have ensued more spontaneous, endemic stability.
In other words, this is again a case of a conflict between the basic value of security Opens in new window (for influential persons and groups) and the aspiration to freedom and justice Opens in new window for all.