Tag Archives: recessions

Why Deficit Spending During Recessions is Good

Why do most economists believe that governments should run deficits during recession? Isn’t borrowing money bad?

There’s some truth to the idea that borrowing money is often a bad idea for individuals and families. But we all know there are exceptions. For one, when there’s an emergency, you might not have any choice. And, contrary to popular analogies, government finances are very different from those of families.

Government revenues (aka “taxes”) are closely related to families’ and companies’ incomes, but that’s about where the similarity ends. When people lose their jobs in a recession, governments collect less in taxes. When corporate profits decrease, governments collect less in taxes. And we’re talking about governments at all levels here, from local to state to federal.

So what do governments do when they’re receiving less revenue? Local and state governments essentially have to run balanced budgets by law, so they cut spending. And this hurts the economy even more, causing more unemployment, and leading to even less tax revenue. What’s worse, the effects of decreased government spending get multiplied as the reduced money flows around the macroeconomy.

To be fair, there are natural forces that do eventually help economies recover. Real wages may fall to the point where companies finally start hiring again, for example. Eventually economies do tend to right themselves. The key word here is “eventually”. Unfortunately, it can take a country’s economy a decade or more to “fix itself”. Look at the Great Depression, or Japan’s Lost Decade.

To help the economy recover faster, we need to make up for the decreased investment spending by firms and decreased consumer spending. For better or for worse, the only entity in a position to do that is the federal government, since unlike state and local governments it is able to borrow money fairly easily.

As a result, the best minds in economics say that running a federal deficit during recessions is a good idea. Doing so will help to pull the economy out of the recession faster, and will reduce its severity.

There are some caveats, though.

Most importantly, governments should not be running deficits during expansions. If anything, the federal government should be running surpluses during expansions in order to pay down the public debt. This helps to clean up the government balance sheets in preparation for the next recession. Unfortunately, U.S. governments have shown an inability to do this. With the exception of the late 1990s, when politicians have seen surpluses, they’ve seen the opportunity to buy votes with tax cuts. This sounds good to many voters, but it’s bad news for the economy.

Second, borrowing money even for good reasons has implications. For one, you have to pay interest on it, and that costs money down the road. This is another good reason to pay down the debt during expansions.

Third, someone has to be willing to lend you the money. So far, the interest rates that the U.S. has to pay for the money it is borrowing are still low, partly because most other countries are even worse shape than the U.S. But as public debt as a percentage of GDP continues to increase, the interest rates the U.S. government will have to pay are bound to eventually start to increase, and that can cause serious problems. See Greece, Spain, and Italy for more of that. At the end of the day, no government can continue to borrow more and more money at an increasing rate indefinitely.

So the bottom line is that deficit spending during recessions is a necessary evil. Economists don’t like governments having to borrow money, but in downturns, it’s for a good cause. But there’s always a trade-off, and there are limits to how much any government can and should borrow. Eventually we’re going to hit those, and at that point we’ll have run out of options.

Cue the Irony: Australia on the Verge of Recession?

Mere hours after posting about Australia’s amazing 21-year stretch without a recession, I read that Australia could now be on the verge of a recession.

According to the New York Times,

Australia faces a gathering threat to its 21-year run of recession-free growth that will probably require the central bank to cut interest rates to record lows and keep them there for some time, if the winning streak is to stretch to 22.

The slowdown in China has deflated prices for Australia’s main resource exports while forcing miners to scale back on their most ambitious expansion plans. When the country reported its widest trade deficit in three years for August, it seemed just a taste of what was to come.

I wish I could say that I predicted that.

Recessions as Economic Earthquakes, Business Cycles, and the Australian Miracle

Economists know a lot about recessions. We know things that influence them, the dynamics of how they develop, what affects how they evolve, and hundreds of different ways to analyze and quantify them.

But we still can’t predict them. And, for all practical purposes, we can’t say definitively what “causes” them.

Recession are kind of like earthquakes. Seismologists and geologists understand a lot about earthquakes. But they still can’t predict them.

You’ll hear some “experts” saying that they know exactly what causes recessions. They might think they know, and even believe they know. But they don’t know. Not well enough to be able to predict them, anyhow.

And you’ll read that Person X predicted the last recession, with the implication that  Person X really knows everything there is to know about recessions and economics, so you should always listen to Person X.

I don’t buy that. I don’t put much stock in people who claim to have “predicted” such and such economic event. For one thing, if you predict a recession enough times, you’re going to be right eventually. People predict recessions all the time – a “the sky is falling” financial crisis book comes out roughly every 3.9 minutes. Eventually there’s always a crisis, and the authors claim to have predicted it. Only they’ll conveniently forget about the 27 false alarms they had before they finally got it right.

Part of the problem is that economies are just too complicated for people to be able to predict much about them very accurately. Far too many unpredictably things affect economies. Weather. Revolutions. Politics. Elections. Wars. Politicians. Dictators. Terrorism. The individual choices and decisions of 7+ billion consumers. There’s just no way to take all those things into account and come up with useful and reliable predictions.

Yes, we can forecast, but it’s basically trying to quantify chaos theory. The best anyone can do is maybe come up with probabilities of certain outcomes. And even those will be iffy.

About the only prognosticator I give much credence to is Warren Buffett. And even he admits that he makes mistakes.

So the next time someone tells you that you have to believe what Person X says because he/she predicted Y, ignore it. If someone manages to predict three recessions in a row without any false alarms, they’ll have my attention.

***

So what is a recession, anyhow?

The textbook rule-of-thumb definition is two or more consecutive quarters of negative real GDP growth. In other words, whenever an economy shrinks for 6 months.

In truth, it’s more complicated than that, as reality often is. For reasons that are still imperfectly understood, economies tend to move in an up-and-down cycle. They grow for about 2 to 10 years, and then shrink for about 6 to 24 months. The periods of growth are called expansions, and the periods of shrinkage are called recessions.

The two-quarters-of-negative-real-growth rule usually is close enough for government work. But not always. What if an economy shrinks substantially one quarter, grows 0.1 percent the next, and then shrinks some more the next? By the rule of thumb, there’s been no recession, but that’s cold comfort to the people who lost their jobs. And that sort of thing does happen.

To sort this stuff out, the U.S. National Bureau of Economic Research (NBER) actually has a committee of some of the best brains in macroeconomics. In true economist fashion, it’s creatively called the Business Cycle Dating Committee. They meet whenever they see the need to pore over reams of data and decide when the most recent business cycle began and ended. In the process, they’re deciding when the expansion and recession were.

So here’s the actual NBER definition:

 A recession is a period between a peak and a trough, and an expansion is a period between a trough and a peak. During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. Similarly, during an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years.

So a recession is “a significant decline in economic activity spreads across the economy and can last from a few months to more than a year”. In other words, an econquake.

As a public service, I’m including the NBER’s dates of all U.S. business cycles since 1854.

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One of the few things economists are absolutely certain about is that business cycles happen. We don’t know exactly why, and we can’t predict them all that well. But they do. Over and over people have claimed that we’ve beaten the business cycle, that there won’t be any more recessions. And over and over, they’ve been proven wrong.

If someone tells you that there’s no more business cycle, they’re trying to sell you something.

Yeah, yeah, economists are dismal scientists. We’re always predicting gloom and doom. But unfortunately we’re always right about that. Eventually, anyhow.

So when I read that Australia hasn’t had a recession in 21 years, I was suspicious. That was something I had to check out.

So I looked at the data. And sure enough, it’s true. By the textbook definition, Australia hasn’t had a recession since 1991. They’re not even having one now. The U.S. had recessions from March to November 2001, and from December 2007 through June 2009. But Australia’s economy kept growing, if somewhat more slowly.

So how did Australia avoid the Great Recession and the recession(s) before? What’s Australia’s secret? Have they found that Holy Economic Grail, the key to overcoming the business cycle?

That I seriously doubt. But answer that “how” question will probably decades to answer; economists are still debating the Great Depression, and that was 80 years ago.

And in true dismal scientist fashion, I’d like to point out Australia did have at least two slowdowns during those 21 years. They just weren’t severe enough to amount to “negative growth”.

Either way, it bears looking into. I’ll try and give it a shot in a future post.