Can the government help in a recession?
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.
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.
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.
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.
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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