Can the government help in a recession?

by Philip Brewer on 1 January 2008 5 comments
Photo: Philip Brewer

Recessions spread. A minor downturn in one business spreads to its suppliers and then to their suppliers. Workers are laid off (or simply fear that they will be) and buy less, spreading the downturn to other sectors of the economy. Since the 1940s, governments have tried to act to limit the damage caused by recessions, but not everyone agrees that government action can help.

Let's start with the theory that governments can help in a recession. It's worth understanding, if only because it's the theory that's generally accepted by the people who actually control government action, so it's the theory that guides what the government actually tends to do.

Economists classify recessions depending on how they start.

Consumer-led recessions

Sometimes consumers just start to buy less. That can happen either because their budgets are squeezed (such as by rising oil prices) or because their confidence is shaken (such as by rumors of war) or both (such as by falling home prices).

Companies seeing a downturn in business order less; their workers buy less (especially if they lose their jobs); pretty soon everyone is doing less business and you've got a recession. "If only," the economists muse, "there were someone who could go ahead and keep spending as if there were no recession." Which led to the insight that governments could go on buying as if there were no recession. That would tend to put a floor under possible declines in economic activity.

Of course it's a small step from there to having the government spend more during a recession, in an effort to kick-start economic activity.

Business- or finance- led recessions

Sometimes businesses (or their banks) cut back even before consumer activity shows a downturn. That's most likely to happen when they fear a downturn and want to position themselves in advance.

There's a call for governments to act as "spenders of last resort" in this situation as well. Especially in finance-led recessions, though, there's also a call for the Federal Reserve to reduce interest rates as a way to head off a finance-led recession. (And, since nowadays finance-led recessions are almost always started by the Fed having raised interest rates, this makes a certain kind of sense.) In other countries, replace "Federal Reserve" with the name of your central bank. It's all about the same.

The contrary view

Not everyone agrees that government action is appropriate when a recession threatens. These skeptics are rather more common among the net-savvy crowd than they are in the halls of government, but it's a position that has advocates even there.

There are two threads to the contrary view.

Government-caused

Even within the mainstream view, there's agreement that recessions are often caused by government action. Ordinary policy actions have some effect on the economy--and actions taken to "fine-tune" the economy especially so. Tax increases, budget cuts, and regulatory actions tend to suppress business activity. (Tax cuts and additional spending--especially deficit spending--tend to increase business activity, but even that can cause problems, as I'll discuss in the next section.) Even ostensibly neutral actions can shift money around in the economy, boosting one sector while suppressing another, and it's impossible to know whether on balance the result will make a recession more likely.

Of course, the main way the government causes recessions is by raising interest rates. The central bank does this to head off inflation (caused by the central bank actions that lowered interest rates earlier). This cycle is often compared to driving a car by alternately stomping on the accelerator and then the brake.

While everybody agrees that policy actions have effects on the economy, the mainstream view is that this means we should carefully consider policy actions and try to balance the effects in ways that minimize the harm--and if actual results in the economy show that things have gone awry, the government should take further action to try to "fix" the problem.

The contrary view is that the government action is the problem, and that there's no way that more of the problem is going to make things better. (People like to compare it to having a drink to treat a hangover.) The policy recommendations that come from this perspective tend to support low taxes, low spending, less regulation--basically, less government altogether.

Malinvestment

The other thread is a bit more technical. The theory is that in any business expansion, there will be people who make unwise investments. There will always be people who are too optimistic, too confident in their own forecasts, or who simply misread shifts in people's tastes.

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If there's only a little malinvestment, it can be cleaned up by the people who made it. The swimming-pool installer who bought a new backhoe, figuring that global warming would mean that his business could only go up, may find that the housing downturn has made it tough for many of his customers to get the home equity loan they need to pay for a new pool. If nothing else goes wrong, he can probably work his way out of the problem--lower profits while he pays off the under-used backhoe, but not a business failure.

Inflation always causes malinvestment, because inflation fools people into thinking that things are going especially well. Businesses see a surge in businesses, which prompts them to expand. When it turns out that the surge was all illusion (they were getting more dollars, but the dollars were worth less), they've already committed to an expansion that has no future.

Government spending produces malinvestment a well, as businesses gear up to produce whatever the government is buying today. It's obviously not the best use for the investment (or you wouldn't need government spending to support it), plus it's highly vulnerable to being a very bad investment, if government priorities change.

When there's a lot of malinvestment, though, is not so easy to fix. A company that has borrowed to expand, but doesn't get enough business to service the new debt, is in trouble. Even businesses that aren't in debt can shut in a downturn. If business gets bad enough, it's cheaper to just close the doors than to pay to keep the place staffed and the lights turned on.

The key here, though, is that an investment is only malinvestment if the price is too high. That is, the pool-digger's extra backhoe may be a lousy investment at $100,000, but if someone else can pick it up at a liquidation sale for $50,000, that might not be malinvestment at all.

So, the thrust of this thread is that recessions are how malinvestment gets worked out of the economy. Some business go under, others sell off underperforming pieces. The result is an economy where productive assets are reallocated to where they can be used profitably--at which point the stage is set for a sound recovery. If the government heads off the recession, by cutting interest rates too aggressively, or by buying whatever it is that isn't being bought, the malinvestment goes uncorrected, leaving potentially productive assets in the hands of people who can't use them to their best effect, while leaving other people (who could use them) unable to thrive.

Can the government help?

People on both sides of the issue see that government action leads generally to malinvestment. For the people who advocate for the government trying to help, that's unavoidable--and simply needs to be dealt with by more government action. For the people who advocate against, it's a reason for the government to do as little as possible.

As to whether governments can help in a recession, the answer clearly depends on where you stand. Cutting interest rates is great for people who have variable-rate debt (or would like to), but it sucks for people who have cash. Higher government spending is all well and good for people who build roads or grow corn, but doesn't mean much for the guy who runs a bakery or works at a video store (except, eventually, higher taxes).

In the end, the people who are helped are very specific and very aware of the help, while others are either not harmed, or are harmed only in a diffuse, general way (along with everyone else). The result is that the political pressure always tends to be on the side of more help. Whether it helps the economy or not, it definitely helps the people who get it, and that's enough for the politicians to keep at it.

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Guest

A couple of weeks ago, I caught an interesting interview on Bill Moyers. The guest, Benjamin Barber, described the sub-prime meltdown in a larger context that re-framed my perspective of the symbiotic (or parasitic) relationship btw corporate America and government (i.e. taxpayers). I think it is quite relevant to understanding the mechanisms avail to address a recession. Here is an excerpt from the Bill Moyers transcript:

BENJAMIN BARBER: -- It is. But part of the problem here is that the capitalist companies have figured out that the best way to do their job is to privatize profit, but socialize risk. That is to say--

BILL MOYERS: What do you mean?

BENJAMIN BARBER: --ask the taxpayer to pay for it--

BILL MOYERS: Yes.

BENJAMIN BARBER: --when things go down. The banks now that have just screwed up so big, not one of those banks is going to go under because they'll be bailed out by the feds. 'Cause the feds, the federal government will say we can't afford this gigantic multi billion dollar bank to go under. Happened with Chrysler 20, 30 years ago.

BILL MOYERS: Got to keep the wheel going.

BENJAMIN BARBER: And, therefore, it's impossible to fail if you're a business. You never get punished. Now the whole point of profit is to reward risk. But what we've done today is socialize risk. You and I, and all of your listeners out there, pay when companies like sub-prime market mortgage companies and the banks go bad. We pay for it. They don't.

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jkjk

A hands-off approach is generally expected to be worse than intervention. Prior to the Great Depression, government intervention was minimal, and the economy regularly went into depressions, not simple recessions. The pain of the GD was so great that we swung over to the other direction, and went into heavy deficit spending and government intervention. Then, later, during the 1960s, we shifted toward our current monetarist policy, where the government intervenes, but primarily by controlling the money supply.

We've averted depressions, and suffered only "recessions". Now, to the average worker, a recession feels like a depression, but, at least the larger economy doesn't collapse. The wealthy now experience recessions as short-term losses, but not as life-changing experiences. Maybe they lose their business, but they don't really lose their shirts.

Perhaps a direction to explore are ways to use government spending during recessions to ease the pain on some average workers. During the potential recession, the people most likely to suffer the most include construction workers, who are already experiencing wage declines. I think it would be rational to examine the backlog of needed infrastructure repairs, and then do those that are possible using these workers. The taxpayers get to take advantage of this downturn in wages, the workers find their wages lifted, and some workers who wish to transition out of the job will have an extra year or two to re-skill.

We could use this housing downturn to alleviate homelessness, for example. We could use this labor to rehab marginal properties that are distressed. The government could acquire the properties, rehab them, and turn them into transitional housing.

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Guest

@jkjk

One Great Depression isn't a very large sample, so it's hard to tell if non-intervention would work. But I like the idea of public works projects, such as Roosevelt started in the 1930s. We could restore meanders to rivers, build rail-trails, clean up superfund sites, fix up the lodges in national parks, help poor states maintain their parks, build sidewalks in the benighted neighborhoods and plats of the past few decades where they weren't included.

The problem with this vision relates to the first comment (Barber-Moyers) above. Under current government, probably including a Democratic administration, the work would be outsourced, done by a corporation, perhaps Blackwater, rather than by a government agency as in the New Deal. This, of course, was already happening at least as early as the Eisenhower administration with the make-work Interstate Highway project.

Except for that, such intervention could help a lot of people.

Very clear analysis, Philip.

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jkjk

I probably didn't clarify this, but, it's the decades before the GD that are evidence that intervention works. The country experienced periods of depression during the 19th and early 20th century. This link has some information... http://www.thehistorybox.com/ny_city/panics/panics_article1a.htm

Basically, capitalism was still starting out, and unregulated money, markets, and industry just did what they wanted. The effect was depressions. As capitalism grew, so did the scope of the depression (as more people were working for wages), and regulations followed.

The GD is so iconic because it was the last depression. Since then, we've had recessions.

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Stumpy Joe

jkjk is right about the need for government to intervene when recessions or depressions are looming. The way I see it, depressions happen when people don't have enough money to pay for the things they need. Although jkjk has the right idea when he talks about the government providing jobs to construction workers, I think there is a quicker and more direct way the government can help. It can have a massive stimulus plan by printing lots of money for us. We could each get a $10 million stimulus check from the Treasury. Then we'd all have the money we need to buy the things that we couldn't before. That should put off a depression for a long time and make us the richest country again. Obama '08!