Thursday, July 10, 2008

Can Recessions be Avoided?

This is certainly a topic which will bring a heated debate amongst economists. It is a difficult question to answer and to some extent depends upon the circumstances of the economy. These factors influence whether recessions can be avoided.

Natural Trade Cycle.

For a long time it was felt that economic growth was subject to a natural cycle of high growth (booms) followed by low growth or recession. It was felt that it was not possible for intervention to prevent these cycles. However, in recent decades, it appears that economic cycles have become less pronounced; i.e. booms less noticeable, but recessions shorter and deeper. Therefore, although it is not possible to smooth the business cycle, it is possible to minimise fluctuations so as to avoid an actual downturn. Some have credited independent Monetary policy as helping to minimise trade cycles

Global Trade Cycle

Due to forces of globalisation and the interdependence of world economies, a recession in one country often causes a recession in others. For example, a recession in the EU, would definitely affect the UK economy because the EU is our main export partner. When the world economy slows down, a recession is harder to avoid in your country. However, individual countries may do much worse or much better than the global trend. For example, in the downturns of 1981 and 1991, the recession in the UK was much deeper than the rest of the world. Whilst the government could blame some of the downturn on the world economy, the biggest factor was the individual circumstances of the UK economy.

Booms Can Be Avoided.

The best way to avoid a boom and bust, is for the government / monetary authorities to avoid a boom; if the economy expands too rapidly and inflation occurs, there comes a point when it is almost impossible to avoid a recession. If economic growth is kept close to the long run trend rate and you avoid speculative bubbles in the housing market, this is the best way to avoid a recession. If the economy is allowed to grow above the long run trend rate, then a bust becomes an almost inevitability. For a case study see: Lawson Boom and Bust of late 1980s.

Oil Shocks

Some economic factors are beyond the control of governments. A rapid rise in oil prices creates a situation of stagflation; rising inflation and falling living standards. It presents a difficult situation. The Central bank is caught between raising interest rates to control inflation and cutting interest rates to boost growth. There is a limit to what can be done, when there is a supply side shock. Whatever policy is implemented there is likely to be a worse trade off. The current oil shock makes it very difficult to avoid both inflation and recession.

Fiscal Policy

Fiscal policy is the classical response of Keynesian economics. In a recession, the aim is to boost Aggregate demand through cutting tax and increasing government spending. In theory, this injection into the economy can boost demand and stimulate the economy. To be effective expansionary fiscal policy requires:
  • Low government borrowing. If you already have very high levels of government borrowing, it becomes difficult to finance further expansionary fiscal policy.
  • Responsiveness of consumers. Cutting taxes may not always boost consumer spending, if people prefer to save the money. For example, high debt levels encouraged many US consumers to save their tax cut.
  • Possibility of Crowding out. Higher government spending leads to lower private sector spending
Fiscal policy may not be able to avoid all recessions; but, in some circumstances can help minimise the severity of a recession. The worst thing is for a government to try and balance its budget in a recession like the UK government did in the early 1930s. See: Does Fiscal Policy solve unemployment

Monetary Policy
  • Cutting interest rates should make borrowing cheaper and stimulate demand. However, lower interest rates don't always work
  • If confidence is very low, people may not want to borrow, even if borrowing is cheaper. e.g. Japan had 0% interest rates in the 1990s, but, failed to stimulate the economy.
  • Monetary policy can be constrained by inflationary pressures in times of cost push inflation.

I would suggest governments can cause recessions through irresponsible economic policy. I believe a good example of this is the Lawson Boom; so in a way governments can avoid recessions by not messing things up.

The US government and Federal reserve have tried hard to avoid a recession in the current climate, even at the risk of moral hazard. I believe there steps have minimised the severity of a recession; but, factors like the credit crunch and housing boom and bust are making it very difficult. This would have required a different policy several years previously. Perhaps now it is too late.

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