What is the proper role of government in times of economic crisis?
The consensus opinion among the vast majority economists about the government's role in the time of economic crisis is Keynesian—that the federal government is there to prop up the situation by providing support and stimulus. The role of any responsible modern nation-state during an economic crisis is to lower interest rates and pump money into the economy when demand for goods and consumption of goods drops off sharply. Otherwise, economies collapse, leading to widespread suffering and instability.
We have governments for a reason, not simply because they are a fact of nature like the sun or the moon. They are expensive and cumbersome and never manage to please everyone. Nevertheless, we finance and put up with them because they are a social good, and they protect (or should protect—that's what we are paying for) the general well-being of a nation. A chief part of that is doing everything they can to promote economic stability and widespread prosperity so a nation can be strong and...
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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.