Thursday, October 9, 2008

Why Recessions Occur

Although there are different definitions of recessions, most go along with the concept that falling real output constitutes a recession. (see: definition of Recession) The reasons for recessions are varied. Each recession has similarities but also differences. These are a few examples of major recessions.

Why Great Depression Occured
  • Stock Market crash
  • Banking Collapse led to hoarding of money and fall in investment
  • Deflation caused even more falls in consumer spending
  • End of Boom period and lax credit of 1920s
  • Ineffective response of governments. - Failure to rescue banks, failure to increase aggregate demand
  • Fall in Money Supply due to bank collapse
Note, some factors are caused by the depression and therefore make it worse. For example, because of the recession, prices fall causing deflation. The deflation made the depression worse. Because of the fall in output, unemployment rose. Rising unemployment reduced spending by more.

Government Blame: 9/10 UK government was stupidly stubborn to try and return to the gold standard on the old 1914 level. US monetary authorities allowed an unsustainable credit boom. The response to the depression made things worse. The UK response to cut unemployment benefits and increase income tax in a vain attempt to balance the budget, highlighted the paucity of economic understanding by economists. Increasing tariffs only made things worse.

See: Causes of Great Depression

1981 Recession

Background: High inflation and wage inflation of the 1970s.

  • To reduce inflation, government pursued Monetarist policies. - high interest rates, high taxes and attempted to balance the budget.
  • This caused a fall in money supply and inflation, but, in trying to reach a target for money supply, they deflated the economy too much.
  • Problems of UK were exacerbated by high value of sterling. Sterling was high because of - discovering oil in north sea and high interest rates.
  • The recession particularly affected the manufacturing recession. Manufacturing output fell by a third. Mrs Thatcher claimed recession necessary to get rid of inefficient firms. But, recession was much deeper than necessary. Famous letter to the Times signed by 300 economists criticising the government (see: Economy under Thatcher 79-84)
  • UK Economic Recession 1981

Government Blame 8/10 - There was a need to reduce inflation the government inherited, but, in sticking to Monetarist principles and targetting misleading money supply growth statistics, the deflation was more than necessary causing recession to be deeper and longer than it should have been.

1991 Recession

Background: Lawson boom of the late 80s. High economic growth, booming house prices and rising inflation. Government claimed their had been an 'economic miracle' and trend rate of growth had increased. But, this was not the case. The boom caused inflation.
  • To reduce inflation, the UK joined the ERM in 1990 (fixed value of sterling against the D Mark). The exchange rate value was too high for UK's deteriorating economic situation. To maintain high value of exchange rates, government forced to increase interest rates to 12% (Rose to 15% in one desparate day). These high interest rates reduced inflation, but,
  • Caused rise in home repossessions, people couldn't afford mortgages. House price boom turned to bust.
  • Falling house prices, high exchange rate and high interest rates caused dramatic fall in consumer spending and therefore recession.
Eventually, UK forced to leave ERM. This allowed interest rates to fall and economy recover.

Government Blame - 9/10 Government allowed an unsustainable boom, believing its own rhetoric of an economic miracle which had not materialised. They then pursued the wrong strategy to reduce inflation - Keeping interest rates stubbornly high to pursue a false goal of exchange rate stability when the real problem was unemployment and falling consumer spending. UK Recession 1991

2008/09 Recession

Background: Stable economic growth and low inflation for much of the 2000s. However, boom in house prices, low saving ratios, expansion of mortgage credit and rise in personal debt.

  • Credit crunch. Stemming from US, banks lost money in bad subprime mortgage debts. These debts had been sold onto other banks. This meant a shortage of credit in the financial sector. Lending fell, house prices fell and therefore consumer spending and investment fell.
  • Cost push inflation. The impact of falling consumer spending and falling house prices was worsened by cost push inflation (rising oil prices) which squeezed disposable incomes.
Government Blame 5/10. Governments weren't the main perpetrators behind the credit crisis. But, they can be criticised for lack of sufficient regulatory oversight. US government could have done more to prevent a housing bubble and bust and excessive growth of consumer debt and borrowing
Oil price increase beyond governments control.
Credit crunch, collapsing banks and cost push inflation gave Government difficult problems to deal with.
See: Video on Causes of Current Recession

Of the 4 recessions, highlighted here, I am inclined to blame the government the least for the current recession.

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