Sunday, December 20, 2009

Causes of and Responses to Recessions

In case you haven't heard the news, the "Great Recession" ended sometime over the summer. All that means is Gross Domestic Product (a sum of everything we produce) is no longer shrinking. That doesn't mean unemployment and company profits are back to normal. That's the good news, the bad news is that we, as in the general public, still don't fully understand what causes recessions. As a free marketeer that doesn't necessarily scare me (we don't need to understand it for it to work), but as a voter it worries me. There is historical trend that government power increases in times of uncertainty (Civil War, Great Depression, 9/11). The more we understand economic hardships, hopefully the less fear mongering.

The definition for a recession is when GDP decreases for at least two quarters. That means for 6 months we produced less stuff than we used to. But why? We have the same people, the same buildings, the same machines. The most simple explanation is that recessions aren't economic losses, because nothing is lost that can't be gained back, but are instead economic shifts. In this most recent example, we had a housing bubble. This is due to government subsidies (predicted in 2003) and a general lack of information in the housing market (or tulip market in the 1600's). After the boom busted, houses were plentiful, decreasing housing prices, sending a shock wave into investment and banking. All of a sudden construction workers, realtors, mortgage lenders, etc. are out of work, not buying as much as they would normally and now everyone is hurting. While the unemployed look for new jobs during that transitional period, production is lost. It's important to note, recessions start with loss of production (or mis-production), not loss of spending.

So if that's what causes recessions, how should nations respond to them? Bush and Obama both followed the ideas of John Maynard Keynes. Among other things, he proposed using government spending to counteract the loss in private spending. The idea seems logical, but ignores the fact that any government money comes from present (or future) taxes. Not to say that large government spending can't increase GDP, but that any increase it causes will have at least an equal decrease later. Also, public money is subject to the wills of political officials, with all the inefficiencies and special interest that come along with that. The main opponent of these ideas was Milton Friedman (here's a good rap about the debate). As an advocate for free markets, he proposed waiting through the transitional period and letting things get better on their own. Though he did support government lowering the interest rates to encourage scared investors to come back sooner.

But Keynes is not stupid. If he read this blog post he would agree that in the long run the market would self correct. But he famously said, "in the long run we are all dead". What he forgets is that our children are not. It seems very plausible that Bush's and Obama's stimulus packages increased production and helped some people, in the short run. But our children will be left to pay the bill (but maybe that's not all bad). Yet I must admit, even in a perfect market prices and wages are sticky, which means people don't like to see them change. Much like unemployment benefits, this only makes the transition period longer. Hopefully as time moves on, recession length should shrink due to ease of transportation and internet connections like Craigslist. I personally support allowing the billions of individual decisions of the market to eventually get us back on the road to more prosperity, but I also realize that a government stimulus out of fear is better than electing the next Hitler out of fear.

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