As you may have heard, many left-wing liberals blame the Financial Crisis and Great Recession on free-market economics. (Just like they blamed the Great Depression on too much economic freedom. As the Sacred Scrolls foretell: “All this has happened before, and all this will happen again.”) See what happens when there is too little government, too little regulation! Round up the usual blame-capitalism suspects: Paul Krugman, Joseph Stiglitz, Noam Chomnsky. the Democratic Party.

Of course, folks on the right counter by arguing that if you peel back the onion, the destructive hand of government eventually reveals itself. So who’s correct? Well, Milton Friedman would sure like the conclusion of the new paper “Economic Freedom and Economic Crisis” by Christian Bjørnskov of Sweden’s (!) Research Institute of Industrial Economics:

In this paper, I explore the politically contested association between the degree of capitalism, captured by measures of economic freedom, and the risk and characteristics of economic crisis. After offering some brief theoretical considerations, I estimate the effects of economic freedom on crisis risk in the post-Cold War period 1993-2010. I further estimate the effects on the duration, peak-to-trough GDP ratios and recovery times of 212 crises across 175 countries within this period. Estimates suggest that economic freedom is robustly associated with smaller peak-to-trough ratios and shorter recovery time. These effects are driven by regulatory components of the economic freedom index.

Bjørnskov measured economic freedom by using the Heritage Foundation’s Index of Economic Freedom. He then analyzed subsequent crisis risks as economic freedom changed, and the duration, depth and recovery time of crises when they occurred. He found that “increased economic freedom is only weakly associated with the probability of observing a crisis” and “not at all with the duration of economic crises.” Shocks also tend to be smaller, and the return to pre-crisis real GDP quicker.

So what exactly is the mechanism here? Why apparently are more economically free nations more resilient? Why do they seem to have — to use a Japanese word —  sokojikara,  or reserve strength? Bjørnskov says it is a story about how a more dynamic economy reallocate’s resources:

An interpretation that therefore offers itself is one of reallocation costs during crisis. As a crisis hits an economy, a substantial share of resources become unemployed, which creates profit opportunities for entrepreneurs to the extent that these resources become cheaper. Yet, whether or not this happens and at which speed existing firms and new entrants can reallocate resources depends on the regulatory framework. Licensing requirements and similar business regulations constitute entry barriers that prevent entrepreneurs from seizing legal opportunities and thereby limiting the economic and social losses during crises. Unstable monetary policies and inflationary interventions prevent the formation of precise price expectations, thereby increasing uncertainty, which would also hold back new investments (Friedman, 1962). Finally, labour market regulations can make it both more expensive and risky to hire new employees, providing a third channel through which deficient or inefficient regulations significantly increase the transaction costs of reallocation. Consistent with the evidence, this does not prevent a crisis from occurring, but limits its extent as more firms in a flexible economy can react faster and in a more economical way to the challenges and opportunities created by the crisis.

So some reasonable advice for policymakers, as I see it: First, do no harm. An economic crisis is probably not the best time to launch major new regulatory initiatives. In fact, it would be a good time to look at dismantling regulations that hinder startups (including new banks during a financial crisis.) As economist Michael Feroli has noted, ” … the decline in start-up activity has been a disconcerting feature of this expansion.” Oops.

Second, keep monetary policy stable, preferable through a steady, predictable rule like nominal NGDP targeting. Indeed, the Great Depression/Recession are both stories of monetary instability. And both also saw a big expansion of government’s regulatory power. As economist Scott Sumner explains about the 1930s, ” … a promising recovery in real GDP was aborted in late 1933 by the ill-advised National Industrial Recovery Act, which sharply raised wage rates.”

Third, help workers get back into the labor force or find better opportunities. So think about worker retraining, relocation vouchers, and the harmful effects of non-compete agreements. Distressed economies need more dynamism, not less.