Monday, December 8, 2008

Are Recessions Avoidable?

Many people look to the current recession as an inevitable consequence of several years of decadent borrowing. It's like if you drink too much you 'deserve' a hangover. So the recession is often seen as a kind of a karmic punishment for our extravagance, asset bubble and irrationality.

Yet, the picture is not quite as straightforward. Both Japan and Germany are in recession. Yet, they have had no extravagant boom only a mountain of personal saving, large current account surpluses and in Germany's case a government with a balanced budget. Although, the cause of this current crisis can be traced back to irresponsible lending in the US mortgage sector, it seems that high levels of saving are no protection against recessions.

Anyway are recessions Avoidable?

1. Natural Trade Cycle.

Most economists argue there is a natural trade cycle, which is hard to break. Growth is not constant but comes in peaks and troughs. In this case, recessions are hard to avoid. All we can do is minimise the downturn and prevent an excessive boom.

2. Correction for Booms

If we get an inflationary boom, a recession becomes an almost necessity. For example, the Lawson boom of the 1980s saw economic growth in the UK double our long run trend rate. But, this growth of 5% caused inflation and in reducing inflation we had a sharp slowdown.

3. Avoid Booms and you Avoid the Bust

The theory is that if you avoid an inflationary bubble, then you can avoid recessions. This is why Central Banks are told to target low inflation. If inflation stays low, we can avoid the boom and bust economic cycle. Up until 2006, there was a feeling that Central Banks had brought an end to the trade cycle. (see: When Greenspan was nearly God). Up until this year, the UK avoided a recession for 17 years.

4. Bubbles without Inflation

The feature of the last bubble is that it took a different form. Core inflation remained low. But, there was an asset bubble - house prices rose creating a positive wealth effect, high levels of borrowing, low savings and consumers living beyond their means. Therefore, when the asset bubble burst, it caused a strong downward movement on consumer spending. Therefore, the low inflation masked the underlying disequilibrium in the economy. Maybe if the asset bubble and mortgage defaults had been avoided and the recession would have been avoidable

5. Global Downturn.

The experience of Germany, Japan, China and other countries who rely on exports is that they become reliant on the global trade cycle. As the main economies go into recession, it inevitably spreads the recession to these countries. Even if you follow prudent policies and seek to reduce debt, a global recession will push your economy into recession as well. Maybe their mistake is to put too much emphasis on relying on exports.
  • The main cause of this recession is the global credit crunch, which has been difficult for any country to avoid.
6. Efficiency.

It is sometimes argued recessions are necessary (even beneficial) to create greater efficiency and get rid of inefficient firms. I don't agree with this. Recessions are not necessary to create increased efficiency. Sometimes, recessions can cause good, efficient firms to go under due to cash flow problems.

7. Supply Side Shocks

One contributing factor behind the current recession was the oil price shock in early 2008. It led to interest rate being kept high. There is little governments can do to alter the cost push shock of rising oil prices. It is hard to deal with supply side shocks of this nature.

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