Recession prevention - Los Angeles Times

Much of the sub-prime debacle is hard to fathom, though the simplest explanation is probably the most correct: inadequate regulation led to excessively risky loans, which were then packaged attractively and handed on to the major financial institutions.

The policy responses, however, have been simple–right in line with a textbook analysis. Most fascinatingly, some free-market fundamentalists have called for Keynesian economic stimuli and the US government has responded. Moreover, those pursuing monetary policies have admitted that lags and the banks’ timidity in extending loans (which results in excessive excess reserves) may render the recent cut in the Fed Funds Rate ineffective.

A lot of good relevant articles are around, but you may like the following debate. What side would you be on?

The Keynesian argument (by Jason Furman):

 Once upon a time, economic downturns were looked on as inevitable. Or incurable. Or even a morally justified, righteous cleansing of an economy burdened by the sins of excess. One result of this thinking was the policy mistakes that contributed to the Depression. One of the few good developments to come out of this experience was perhaps the most important economic breakthrough in the 20th century: John Maynard Keynes’ 1936 book, “The General Theory of Employment, Interest, and Money.” Keynes pointed out that in a downturn, an economy simultaneously has idle factories, unemployed workers and too little spending. This creates the possibility of a virtuous circle: Getting people to spend more will put the factories back to work, staffed by the previously unemployed workers. Put another way, in the short run, when the economy is operating below its potential, expanding demand can create supply.

This Keynesian perspective is now standard textbook economics, taught in virtually every introductory economics course. The textbooks teach that policymakers have two tools at their disposal to counteract a downturn. One is monetary policy, which can lower interest rates to encourage consumers and businesses to borrow more and use the money for spending on consumer durables, housing, factories or equipment. The second tool is fiscal policy, which can temporarily increase government spending or cut taxes — again with the goal of raising consumption or investment.

Economists generally prefer that fighting business cycles be left to monetary policymakers because they do not trust the president and Congress to get it right. One fear is that the glacial political process will fiddle and haggle until well after the recession has passed, thus destabilizing the economy and contributing to higher inflation. Another fear is that in an election year, the president and Congress will try to push the economy beyond its capacity, again triggering inflation with little economic benefit. But neither of these arguments is grounded in any fundamental insight; they are just based on a presumption about the political system.

But this time, the presumption about the political system appears to be wrong. The economy appears to be slipping into a potentially serious downturn. The Federal Reserve has cut rates by 1.75%, but lags in the effect of monetary policy mean that much of the benefit of these rate cuts will not be felt until 2009. Fortunately, Congress and the president appear set to fill in some of the gap before 2009. It is likely that in May, June and July the U.S. Treasury will mail out $100 billion worth of checks to working households. If past experience is any guide, at least $50 billion of these funds will be spent — which together with multiplier effects will add about 3% to the annualized growth rate in the third quarter of this year. If extended unemployment insurance or food stamp increases are added to he final package, as demanded by many in the Senate, the macroeconomic benefits would be somewhat larger.

We will eventually need to pay back this money, but an extra year of lower unemployment and higher output will put us in a better position to do so. That is the paradox of economics in a downturn. Normally, the only way to grow the economy is the old-fashioned way: delaying gratification through reduced deficits and increased savings to encourage more investment. But in a downturn, these steps would just compound the problem and worsen the vicious circle of rising unemployment, underutilized capacity and falling consumption. Perhaps we should be thankful that the substantive economic need for a bit of immediate gratification happens to have fallen in an election year.

And the Neo-classical side (by Steven Landsburg): 

 Jason: I don’t think much of our audience will be familiar with Keynes’ “General Theory,” so let me try to boil down your argument to everyday language: First, you think we should put people to work. Second, you think we can do that by getting other people to spend more. Third, you think people will spend more if they feel richer. And fourth, you think we’ll all feel richer if the government mails out a bunch of checks.

Here’s why I disagree.

First, when the government mails you a check, it’s essentially making you a loan. That’s because they’re sending you money that they’ll have to recapture with higher taxes in the future. You are hoping that if we shower people with government loans, we can get them to live beyond their means. The last time large numbers of people were showered with loan money and encouraged to live beyond their means, it was called the sub-prime crisis, which is what got us into this mess to begin with.

Second, the whole thing works only if these checks actually make people feel richer. But when people feel richer, they work less. That’s not idle speculation; it’s a well-established empirical regularity. On a larger scale, it’s why we work 40 hours a week while our much poorer ancestors a century ago worked 60 hours. So — assuming you’re correct when you speculate that government checks will make us feel richer — the average American will buy more but work (and produce) less. That can happen only if the difference comes from abroad. So the stimulus package, if it works at all, is a good way to put Asians to work, not Americans.

Third, it’s not clear you’re doing anyone a favor by putting them back to work in a dying industry. We cannot prop up unhealthy industries forever; sooner or later, workers in those industries are going to have to learn new skills and find their way back into another sector of the workforce. That can be an extremely painful process, but we don’t make it any less painful by delaying it.

In sum, you (along with the president and the majority of Congress) are asking us to:

• shower people with loans to encourage reckless spending;
• somehow expect that the loan recipients will feel both richer and not richer at the same time (so that they’ll spend more without working less), and;
• do all this in the name of delaying the sometimes painful adjustments that are going to have to get made a year down the line in any event.

I object.

About the author: Molly (Mary) Saso teaches AP economics and math at the International School of the Sacred Heart in Tokyo. She has engaged in various occupations (development economist, mother, researcher & writer) since first leaving home (Britain) for Tanzania in 1974, but teaching is her favourite activity, along with reading, making timetables and skiing.

Trackback URI | Comments RSS