How Do You Stave Off a Slump? Have Uncle Sam Play the Market

How the Economy Works:
Confidence, Crashes and Self-Fulfilling Prophecies
By Roger E.A. Farmer
Oxford University Press; 208 pp.; $22.95

A year ago, I wrote a short article for this magazine about an economist with an idea that sounded crazy. Roger E.A. Farmer, a macroeconomist at the University of California, Los Angeles, argued that the government should buy stocks on a massive scale whenever there's a big drop in the market in order to restore the public's confidence and prevent a deep economic downturn. "I get a lot of interest from other economists," Farmer told me, "but it takes a long while for new ideas to spread."

It turns out that Farmer is up to something even more audacious than he explained at the time. He has a bold new theory of how the economy works and doesn't work, explaining persistent unemployment in a way that defies both the new Keynesians on the Left and the so-called new classical economists on the Right. If he's correct, then How the Economy Works is a very important book.

Farmer can't be dismissed as a fringe character. He is a fellow of the prestigious Econometric Society and has consulted for the Bank of England, the European Central Bank, and the Federal Reserve Bank of Atlanta. The British-born Farmer shares some of the ideas of economist John Maynard Keynes, who explained the Great Depression as a self-reinforcing slump in demand. Like Keynes, Farmer argues that confidence plays a crucial role in keeping the economy operating at full capacity. He says the new Keynesians who occupy important positions in academia, starting with the late Nobel winner Paul A. Samuelson, lost that essential insight about confidence when they tried to jam Keynes' theories into the framework of classical economics. In doing so, they built a theory that could not account for persistently high unemployment.

Farmer isn't a pure Keynesian, though. He admires the new classical economists such as the University of Chicago's Robert E. Lucas Jr., whose belief that markets are governed by rational behavior goes back to pre-Keynesian times. Like this cohort, Farmer says he "grew to believe that fiscal policy may not be the right remedy" for recessions.

The core of How the Economy Works deals with Farmer's theory for why unemployment persists. There is no well-functioning market for matching unemployed people with jobs. Ideally there would be special employment agencies that coordinate the market. These hypothetical agencies would pay job seekers and employers for listing exclusively with them and then get paid for making successful matches. Such agencies don't exist because people, unlike wheat, can refuse to be matched if they don't like the buyer.

Unfortunately this is Farmer's most difficult chapter to understand. He acknowledges that "after 12 rewrites, it still retains an aura of impenetrability." After reading it several times and still not fully understanding some parts, I called Farmer and got him to explain it to me—something most readers won't be able to do.

Strange things happen in the absence of a well-functioning labor market, Farmer says. Even when there are lots of unemployed workers, employers don't get any price signal telling them to divert resources to their HR departments and increase hiring. So unemployment stays high. Of course, employers won't hire if there's no demand—but there will be demand if everyone's working. Farmer's point is that any given level of joblessness, low or high, can be stable and persistent. And the best way to sustain a low-unemployment equilibrium is to use the Federal Reserve as a giant trampoline for the Standard & Poor's 500-stock index.

"The only thing that keeps the economy on track is the collective confidence of hundreds of millions of investors that the economy is sound," writes Farmer. "But as experience has shown, investors are sometimes like buffalo grazing close to a cliff: Once a stampede starts in the wrong direction, it becomes a self-fulfilling prophecy that can be very hard to stop." As Farmer sees it, the Fed would announce a target price path for stock indexes and commit to buying shares in a broad-based index fund until it achieved that goal. If stock prices exceeded the Fed's target, it would sell shares. The stock market would be tamed.

How does the government know when stock prices are too low or too high? Might stock purchases convince investors that the government was pouring taxpayer money down a Wall Street rat hole? Farmer neglects these questions. On the other hand, the status quo has not been a huge success. As the U.S. economy emerges from the recession, fresh thinking on how to prevent or at least soften the blow of the next big bust is needed. In the morass of me-too books about the financial crisis, How the Economy Works stands out as a truly big idea. If only it were expressed more clearly.

Market Watchdogs Conspiracy theorists say a government entity has already been buying stocks to prop up the market. Some purported evidence


Former Federal Reserve Governor Robert Heller tells a San Francisco audience that to stabilize stocks, "The Fed could buy the broad market composites in the futures market." He's speaking hypothetically.


ABC correspondent and former Clinton Administration official George Stephanopoulos speaks vaguely on Good Morning America about government plans to come to the rescue "if the markets start to fall."


TrimTabs Investment Research CEO Charles Biderman speculates that shares bought by the Fed and other parts of the government caused the market's strong rebound from its March 2009 lows, with the caveat, "we have no way of proving this."

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