As devastating as this recession has been to the psyche of the general public; nations have endured much worse.Prime examples include our Great Depression, and Japan’s Great Recession. Each of these events unleashed suffrage well over 10 years. In comparison, our circumstance seems rather trivial when placed up against these economic disasters. However, they underscore the overwhelming potential of sustained economic downturn if managed incorrectly. Nevertheless after reviewing these individually, it’s clear that we can establish correlations between the past and current. And, our ability to learn from the past will most certainly determine our future.
In both events, the burst of bubbles triggered the initial economic downturn. When this occurs, asset prices begin to plummet. In most cases, basic monetary policy is the proper anecdote. For instance, the Federal Reserve will reduce interest rates in order to sustain borrowing demand. This is effective in most scenarios because normal economic downturns fail to ravage balance sheets en masse. However in the case of extreme events defined as balance sheet recessions, the drops in asset prices are so devastating that firms begin to change their behavior. For instance, firms will halt borrowing and begin paying down debt. This is known as debt minimization. This occurs because firms must report solvent balance sheets. If firms fail to do so, banks have the power to turn off the credit spigot, and demand cash settlements, placing the firm’s survival in jeopardy (pg. 15). If this is being done en masse, aggregate demand will decline sharply, thus causing a deflationary spiral.
Amidst a balance sheet recession, borrowers show very little responsiveness to interest rate reductions. It’s for this reason that monetary policy is virtually ineffective at combating a balance sheet recession alone (pg 11). During both disasters, Japan and the U.S.dropped interest rates to record low levels, and borrowing demand was unresponsive. So, aggregate demand continued to spiral downwards with no end in sight. It’s then not surprising that unemployment reached 20% and home values dropped on average between 30-40% in the U.S during the Great Depression. It’s imperative to understand that the lack of demand is due to the firms change in behavior. Rather than borrowing for future endeavors, firms are paying down debt. The problem’s root is at the borrower, not the lender. So by attempting to reform the lender will prove futile.
In our current situation, borrowing remains unresponsive despite extremely low interest rates. This is because the economic downturn in numerous industries has been so massive that virtually everybody has been affected. Currently, there are many forces at work that we haven’t seen in this sequence in a long time. These include the energy crisis, housing market, and the financials. I believe that it’s safe to presume that these downturns have been so immense that they have effectively changed firm’s behavior on an aggregate level. Doesn’t this seem eerily similar to past scenarios?
It’s clear that fiscal stimulus is the only route to sustain aggregate demand, because you will not receive it from the private sector.Even amidst objections to fiscal stimulus, careful analysis will prove that these quarrels are unsubstantiated. It’s important to understand that in both Japan and the Unites States the budget deficit increased substantially in the periods without sustained fiscal stimulus amidst a recession in comparison to periods of commitment fiscal spending. Clearly, the fiscal spending during a balance sheet recession is not the ideal situation, but it sure beats the alternative. Japan can stand testament from their 15 years of lost innovation and education. Households were barely staying afloat, and families didn’t have the income to send their children to universities. As a result, they are now beginning to lag behind their Asian counterparts. As can Great Britain who accumulated unspeakable debt during World War II, roughly 250% of their GDP. Should they have just succumbed to Hitler or Stalin? This debt did not prevent Britain from entering an elite status. There is no magic percentage of debt to GDP that sends an economy into a collapse. It wasn’t at 250%, and it’s not where we sit at now. Bring on the doom and gloom, but I’m just not buying it. However, that shouldn’t undervalue the importance of a well managed budget. I do strongly urge that our budget must be handled much more efficiently.
I agree with the route that we’ve taken as a country, but we’re only half way there. Fiscal consolidation should be enacted immediately after fiscal stimulus is no longer needed for growth, and firms have switched to profit maximization. This is when we can begin to chip away at our national debt. However, it’s important that fiscal easing, and then fiscal consolidation occur at the right times. If not, it could send our country back into a recession which would mean more debt and lost time. The future of our economy is in our government’s hands.
Koo, Richard C. The Holy Grail of Macroeconomics. Wiley, John & Sons Incorporated: August 2008.
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There isn't a lot here that I agree with. Let's start with the depth of this recession. If we use the Dow as a measure of how far the Depression went, we'll see that the Dow lost 90% of its value. But, the dollar didn't float in those days. It was pinned to gold.
ReplyDeleteIf you use gold as the common value you will see that the Dow has slipped 90%. So, the financial markets are probably on equal footings. So, the circumstances aren't really all that trivial.
The last statement "the future of our economy is in our government's hands" is really a scary one. Its been in their hands for years, and I don't think they've been doing all that great of a job. We've seen that even with oversight, they have chosen to cast a blind eye to all the garbage that was being dealt on Wall Street and allowed a few Ponzi schemes to get past them. And these are the folks that you would want to oversee all the big things in the economy.
The economy has been steaming along on debt. This debt was allowed and promoted by the Fed. They put too much money into the system and caused bubbles. We had the high tech bubble back in the late '90s, the housing bubble in the mid decade, and last year it was the oil bubble. The Fed is supposed to protect against the bubble. It failed. With all the liquidity in the current economy, its only a matter of time until the next bubble forms.
If you recall back in September of last year, the government told banks they had to value their assets on a mark to market basis. Since the market was gone, those assets were valued at $0 and banks failed. There was value in the underlying market and those assets were giving a return on investment. Back in February, they relaxed that ruling and banks returned to profitability. But, they weren't lending to each other. The markets lacked liquidity.
TARP was originally meant to consolidate the financial markets. The original purpose was to allow strong banks to buy up weaker banks. This would dilute those toxic assets with strong assets and remove the ineffective management. Instead, public pressure didn't like the idea, and it was changed that the government should prop up failing banks. That lousy management is still in place.
The stimulus hasn't really kicked in. I've heard reports that only 10% of that money has been spent. That has gone to states and they have used it to balance budgets instead of funding new projects. This has put money in state coffers, but little has trickled into consumer's pockets. Cash for Clunkers has shown what happens when you put money directly into consumer's pockets. It ain't rocket science, but somehow government thinks all things have to be mired in bureaucracy in order to be effective.