What is the proper role of government in times of economic crisis?
There is considerable debate on this question among various economists.
The general mainstream view is called the New Neoclassical Synthesis: Based primarily on the work of John Maynard Keynes, it says that the government has a vital role to play in stabilizing the economy during times of crisis by two basic methods.
The first is monetary policy, the decision of the central bank as to what target interest rates to set, which determines the amount of money in circulation. When the economy is in recession, the central bank should lower interest rates to increase the amount of money in circulation and thereby offset the recession.
The second is fiscal policy, the decision of the government as to how much to spend and how much to take in taxes. During recessions, especially very severe recessions where monetary policy is insufficient, the central bank should run a cyclical deficit, spending more money than they take in taxes, in order to increase the demand for goods and lift the economy out of recession. Then, once full employment is restored, they should balance their budget or even run a surplus in order to pay down the debt they incurred in the recession.
This is the mainstream view, but there are many economists who believe that it is no longer adequate. At the extreme left there are Marxian economists who believe that the government should take a great deal of control over the economy; at the extreme right there are Austrian economists who believe that the government should have almost no involvement in the economy whatsoever. There are also alternative centrist views, such as those that apply insights from behavioral economics to understand the causes of recessions and find better ways to prevent them or respond to them.
There is a division in thought of the actions expected by governments in times of economic crisis. In such situations, the government is expected to turn the economy around by strengthening the financial sector, increase demand, lower unemployment and decrease the rate of inflation. The free-market system argues that such a crisis is self-correcting as the economy will eventually adjust to the imbalances and move into equilibrium by eliminating inefficiencies. They do not support any intervention by the government in the belief that the flaws that caused the crisis would continue to plague the system. However, those who support government intervention are of the opinion that an economic crisis is a failure of the system. This can only be fixed through fiscal policy and regulation changes, while maintaining the competitive nature of the market.
Both the schools of thought have their place in deciding the actual role of government in such crisis. In fact, it is necessary for the government to act in a mix of both these schools, as it has historically been seen that when one of these systems overwhelms the other, it has been disastrous for the economy in question. The government has to look out for the market because it needs the returns for its own functioning and existence. Federal structures rely on businesses for employment, investment, production, and revenues. For the market to provide these reliably, it needs the government to provide a regulatory and business environment conducive for the same.
The appropriate action of a government in a crisis would be to maintain an open economy to boost demand, and reform the financial systems. This would allow the economy to emerge with a lower sustaining capability for public spending, while raising fiscal deficits and public debt. Though the period following this would not be marked by high rates of growth, but by reforming existing programs, it would be possible to reduce spend. The government should also reduce taxes to increase public spending and investment, even if it results in a deficit. By engaging in deficit spending during the times of an economic crisis, funds can be made available to financial institutions, thereby increasing lending and the aggregate demand.
However, this is where the government also needs to confirm to some standards of the free-market system. For the above deficit to be effective, the increased spending should be of benefit to counter the crisis. Internally, the government needs to analyze its expenses and remove inefficient and wasteful ones. The spending that is carried out should be focused on increasing employment and production, rather than just consumption.
This is an ideal method of operation by governments in times of economic crisis. However, we see such situations persist mainly because most governments do not operate ideally in such scenarios.