Friday, August 5, 2011

Causes of Double Dip Recession

A double dip recession refers to a second period of negative growth (fall in output) that many economies are now facing. Some economies may just avoid a technical recession (with very low growth) but with spare capacity and in the aftermath of a recession, very weak growth will have all the signs of an actual recession. (i.e. higher unemployment, decline in living standards e.t.c)

Reasons for 2011 Double Dip Recession

1. Credit Crunch. The reasons for the credit crunch are well documented. In short banks lost billions through mortgage defaults. They either did this directly or indirectly through the whole complicated network of credit default swaps. The financial system has never fully recovered - bad loans and loss of confidence.

2. Balance Sheet Recession. The great recession of 2008, was not due to a temporary period of high interest rates or deflationary fiscal policy (like in UK in 1981 and 1991). The last recession was because of fundamental imbalances in the banking / housing sector. This is much more difficult to recover from. For example, interest rates were cut to zero in EU, US and UK, but low interest rates weren't enough to encourage strong lending; it remains an example of a liquidity trap. Banks are concentrating on improving their balance sheets, and even now, there is a greater reluctance to lend, and banks are being more cautious.

3. Budget Deficits

The 2008 recession was not caused by government borrowing. But, as a result of the recession, governments saw their deficits increase (lower tax revenues). Budget deficits also deteriorated because many governments took on the bad debts of private banks (especially in case of Ireland, and to a lesser extent UK, US)

After initial attempts of fiscal stimulus seemed to help economies recover. e.g. UK economy recovered in 2010 following tax cuts / lower interest rates, governments shifted their focus from boosting growth and reducing unemployment to targeting the budget deficit. (Austerity economics)

The new UK government came to power promising to make cutting budget deficit as highest priority. The spending cuts and tax increases definitely damaged consumer confidence and are a significant factor in UK growth being very disappointing.

EU Debt Crisis.

For various reasons, the EU has been sucked into a debt crisis.
  • Euro member countries don't have a lender as last resort, thus liquidity problems can become insolvency problems. (see: problems of Euro)
  • Markets worried over lack of political ability to deal with fiscal crisis.
EU Problem

In 2010, there were some hopeful signs for the EU economy. German manufacturing was bouncing back sharply. Many European banks had avoided the bad bank loans of US and UK. But, growth in the EU has remained depressed because:
  • Countries focused on austerity (spending cuts) without corresponding monetary boost.
  • ECB have remained bizarrely concerned with inflation and threatened to raise rates, despite stagnant growth and high unemployment.
  • Lack of flexibility in the Euro. The Euro undoubtedly creates greater inflexibility. Countries which have lost competitiveness over time (Greece, Portugal, Spain) have few options to boost growth and exports through devaluing exchange rate.
Global Recession

The current downturn affects all major economies. Problems in Europe are feeding lower growth in US and vice versa. Some developing economies (China and India) are doing well, but they don't have the same spending power to boost exports in the west.

Commodity price Increases

The unbalanced nature of growth in the economy, combined to cause a rise in commodity prices (rising demand from the East) at the same time as economic stagnation in the West. Certainly this contributed to lower real wage and held back consumer spending. As well as the impact on disposable income, the cost push inflation (rising food / petrol prices) contributed to a general economic malaise - you can almost hear people say 'we've never had it so bad'

Housing Markets

In US and some EU countries like Spain and Ireland, housing markets have remained depressed, with house prices continuing to fall. This depression in house prices has led to bank losses, and lower consumer spending.

Government Policy and Priorities

To a large extent, I blamed the 2008 recession on the problems of the financial sector. In hindsight the government should have done more to regulate banks / mortgage firms (especially in US). But, the recession had a clear cause beyond the governments.

But, in the double dip recession, I don't feel the same. More than anything, governments have failed to target growth. The EU, the UK (after last election) and now the US, all see 'reducing budget deficits' as primary economic objective. Yet, the sad thing is that austerity policies at best do very little to improve debt / GDP ratios. Western economies do need structural change to deal with rising entitlement spending and ageing populations. But, you don't solve a long term structural deficit by slashing spending in the mouth of a recession.

The US and UK, at least have some hope that monetary policy (exchange rate) and quantitative easing can provide some monetary stimulus to offset the negative growth. (though there are problems to relying on more rounds of quantitative easing with uncertain effects). But, the periphery of Europe is facing a grim future.



Anonymous said...

I have a hunch that Keynesian responses to recession work best in industrial countries such as China and 1930's USA as opposed to post industrial societies such as the US and UK.

In the great depression consumption and production were, generally, in the same countries, e.g. cars produced in America would be consumed (bought) in America.

Would it then follow that the positive multiplier effect caused by stimuli money would be greater in an industrial nation than a post industrial country?

In the past three years I haven’t heard anybody mention this so I wanted to hear an expert opinion.

Tejvan Pettinger said...


please see

Keynesian economics

Anonymous said...

The multiplier in an open economy is lower (basic macroeconomics). Post industrial countries are more open than they were in the past 50-60 years, and the stimuli will not be as effective as in the past.
The problem is to quantify how much this spear is blunt.
There is no agreement upon these estimates, someone said the multiplier was nearly 1.5, someone said it was nearly zero and someone else argued that it was actually negative!
As far as I can see the problem is that a pure keynesian stimulus, given the nowadays economic hypotheses, is very unlikely to reach its aim (or, at least, just partially). I strongly believe, we should rethink Keynes' lessons and try to implement some surgical solutions in accordance with his theories (that in my opinion are totally correct).