An attempt to explain appropriate government recession policy (wonkish)
Basic economics of recessions.
originally posted as Facebook Note by Al Petterson on Wednesday, June 9, 2010 at 2:54pm
I encourage comment, on how to make it clearer, or how to address points left out.
In a normal economy, everyone (okay, everyone who has a job -- every "household") is a consumer and a producer. (I'm talking big picture here. Each individual doesn't always do this. The economy as a whole does.) You go to work, you make something (some goods or services or information or whatever), your employer (or you yourself) sells the stuff you made and pays you out of the proceeds, and you take the money you earned and you go out and buy stuff other people made. And here's the big, critical piece: the total amount earned by everybody and the total amount purchased by everybody winds up being the same, in the big picture.
The reason why this works goes to the fundamental nature of economics: the reason we want money is that we want to spend it on something eventually - either now, or to hang onto it until we need to spend it at some future time. We get money by working - producing stuff that somebody else wants to spend money to buy. But the only reason to want money is that eventually we get to spend it. Thus, you don't work for money you don't anticipate ever needing. (Someone might do work for other reasons, and wind up getting money they don't ever need, or producing something they don't get paid for, but we can ignore that as not really affecting the big picture in a significant way.)
It may not seem like this really balances out. Not everyone spends everything they make, of course. Prudent people save money for the future. But meanwhile, people in trouble, or retired, or going through a change, or investing in their future (with education, for example) spend down their savings, or go into debt to buy a house or a car - and that offset winds up balancing out. Any dollar earned eventually gets spent somehow. The point is that unless savings rates are changing overall in the economy at large, the total amount produced and the total amount consumed winds up the same. Or as economists put it, an excess of supply in one market means there's an excess of demand somewhere else. The reason people don't buy X is that they'd rather buy Y.
Remember that point, especially the "unless".
It's not a perfect system, because we don't anticipate the future perfectly. Some companies don't sell enough, so they have layoffs or go bankrupt. But that (in a normal, non-recession economy) doesn't mean people are buying less, it means people want to buy something different than what's being sold. So that company goes under, and the people who were working for it go to work somewhere else where they're making stuff someone actually wants to buy. And so on. These "disruptions" are happening all the time in a healthy economy. If X isn't selling, people stop making as much X and go get hired to make more Y.
Also, in a healthy economy, you mostly want the government out of the picture (from an efficiency standpoint). There do exist market failures where the government has to intervene, there are some cases where the market doesn't appear to work well, and because of this there's thriving and vibrant debate between progressives and libertarians about where those lines are drawn and how much the government ought to step in. But most people agree that for most of the economy, most of the time, you let the market handle the generation and distribution of stuff, and it does this job, of producing what people want and providing it to them at a fair price, pretty well. (The progressive/libertarian debate about the size and scope of government is for another time. It doesn't actually enter into this.)
So what happens in a recession? Well, first off, sometimes something bad happens to trigger it -- perhaps interest rates are set too high for too long (to prevent inflation, which is yet another topic) so companies can't borrow and invest, or some bubble (stocks, housing, tech) bursts, or a war starts, or there's a major technological disruption causing more than the normal amount of layoffs to happen, or some sector of the economy partially collapses (e.g. the financial sector, or the automobile industry, or the banks), or some other country starts out-competing us, or whatever. And because of whatever it is, a lot of people lose their jobs. And then what can happen is that people in general, even the people still working, get scared. They still want to work, but they don't want to spend. They want to save more of their money, because they think they might need it later. They are less inclined to borrow and invest. Overall, savings goes up and spending goes down -- and this comes back to the point I made above, about production and consumption being the same.
Why is this bad? Because everybody still wants to work, and earn, as much as they did before (or even more, because they're more nervous and thus want more money to hang on to). Which means that overall, everybody wants to buy less than everybody produces.
And that can't happen. You can't have people making more stuff than people want to buy, because that means someone out there is making stuff that isn't selling, which means they can't pay their workers, which means there will be layoffs and bankrupt companies, and there is no new market elsewhere for that effort to move to.
So take a step back and look at the cause. When people save money and don't spend it, they are loaning money to the future. If one person does this but someone else is meanwhile spending money loaned from the past -- spending down their savings, or borrowing money to pay back later -- great! That's how it's supposed to work, and it all balances out (as above) because at any time there are people in all different situations and doing all different things.
But if the economy as a whole is saving money more than it did - everyone's putting off their big purchases for later, deciding not to buy a big-screen TV after all, or whatever - then there's an imbalance that can't be maintained. On its own, the way this corrects itself is very bad: when people as a whole aren't buying stuff (because the economy looks bad, and they're worried about their own future), companies can't sell as much product, so more people get laid off, so even fewer people are working, so everybody gets even more scared and spends even less.
This can, in the worst case, get worse and worse - it becomes a depression, aka a "deflationary spiral". It's what everyone is terrified will happen in a recession. It's what regularly happened to capitalist economies, most notably ours, up through the 1930s. It's also what a lot of us believe was only narrowly averted early in 2009.
What if companies save money by lowering wages rather than laying people off? The problem is still that they're overproducing. People don't respond to lower wages by becoming less productive; if anything, people tend to respond to lower wages by working longer hours, taking second jobs, and in general trying to produce still more. It doesn't make people feel better about the economy for them to be earning less - if they can't find a way to make more money, they'll cut back more on their spending, because dropping wages makes people just as nervous as dropping employment. And they're right, too - if people everywhere are cutting back even more, demand keeps dropping, and the same deflationary spiral happens as if more people were being laid off.
So what does the government do when faced with a recession? Well, normally, the big thing a modern government does when a recession starts is have the central bank (the Fed) cut interest rates. That makes it easier to get credit: investors and entrepreneurs can then borrow money at better rates. (From whom do investors borrow? From money in a bank somewhere that someone is saving against future spending -- they're borrowing from someone else's future. Remember that - borrowing is done against future spending, not present spending.)
Why does easier credit (lower interest rates) encourage investment? Because investment has two costs: interest on the money, and risk that the investment won't pay off, and those two costs are added together. If the cost of borrowing money goes down, investments that weren't worth it before (interest rate plus risk) are now worth the risk -- so investors are more willing to expand or start new businesses if the cost of borrowing the money for it drops. And those new or expanded businesses will employ additional people. And when more people are employed, they have money to spend -- i.e. demand starts increasing overall -- and when demand is increasing, investment becomes a better risk, so more investment happens, so even people get hired to meet that demand and thus have jobs, and then everyone starts feeling better about the economy, and spends more of that saved-up money they'd been waiting to spend, and everything gets even better. And a lot of those entrepreneurial ventures even succeed, and we get more and better goodies out of it. (And eventually this can heat up too much, and inflation can happen, which as I say is a different topic, and which leads to the Fed increasing interest rates to make borrowing harder, so it can cool down.)
And those lowered interest rates are how we got out of most of the recessions from the 50s through the 90s. But with the Great Recession of 2007-2009 (and to an extent the one before it, in 2001), interest rates were already really low going into the recession, and the Fed couldn't cut them any more... and the favorable environment for investment wasn't actually producing investment. Getting more products out there wouldn't have helped, and investors saw it: it's not that the wrong products are out there, it's that no product is the right product if people want money more than they want stuff money can buy. Everyone (overall) was loaning money to the future. There was plenty of money out there available for entrepreneurs and investors to borrow, but entrepreneurs and investors looked at the national mood and the national economy, and they didn't see a lot of untapped markets - they didn't see anything people would be willing to part with their savings to buy more of. Because people were scared of the economic situation, and trying to save whatever they could.
And even though the recession's technically been over for a while, growth and employment are still sputtering. For as long as unemployment remains high and the economy overall looks crappy, people will keep holding off on big and optional purchases, and the economy will stay crappy and unemployment will stay high.
So what's left for the government to do?
What's left is borrowing money from the future, to offset the imbalance in the rest of the economy. The government runs a deficit and spends money it doesn't have yet -- exactly like lowering interest rates would encourage entrepreneurs to do, if the economy were only in a normal recession. Why does that work when investment doesn't? Because the government doesn't depend on making a profit, so its "risk" calculation doesn't depend on current demand. The government might spend some of this borrowed money to buy certain products out in the market (directly increasing demand), or just give it to people to spend via welfare (indirectly increasing demand by getting money into peoples' pockets); but in the best case it spends it employing people to build infrastructure: repair roads, do basic and applied research, build bridges and power plants and fast-internet backbones and schools and hospitals. In other words, you make government do the stuff government is supposed to do anyway (if you're not an arch-conservative/libertarian), but you do more of it, because people need jobs -- and once people have jobs, they will have money to spend, and when they see that other people have jobs too, they'll feel better about spending it, and they'll spend it on the goods and services that the rest of the economy is producing and trying to sell -- which means the rest of the economy can hire people, people will feel better, people will spend more, and it spirals up instead of down, until we reach full production capacity and full employment.
At which point the government infrastructure projects get finished, and those people go to work in the now-vibrant private sector.
That's why governments are supposed to run big deficits during severe recessions. And it's why they're not supposed to run deficits during normal economic expansion - because then they're competing with private industry and private investment for the available capital out there for loan, and in normal times private industry does a more efficient job of producing products people actually want to buy.
originally posted as Facebook Note by Al Petterson on Wednesday, June 9, 2010 at 2:54pm
I encourage comment, on how to make it clearer, or how to address points left out.
In a normal economy, everyone (okay, everyone who has a job -- every "household") is a consumer and a producer. (I'm talking big picture here. Each individual doesn't always do this. The economy as a whole does.) You go to work, you make something (some goods or services or information or whatever), your employer (or you yourself) sells the stuff you made and pays you out of the proceeds, and you take the money you earned and you go out and buy stuff other people made. And here's the big, critical piece: the total amount earned by everybody and the total amount purchased by everybody winds up being the same, in the big picture.
The reason why this works goes to the fundamental nature of economics: the reason we want money is that we want to spend it on something eventually - either now, or to hang onto it until we need to spend it at some future time. We get money by working - producing stuff that somebody else wants to spend money to buy. But the only reason to want money is that eventually we get to spend it. Thus, you don't work for money you don't anticipate ever needing. (Someone might do work for other reasons, and wind up getting money they don't ever need, or producing something they don't get paid for, but we can ignore that as not really affecting the big picture in a significant way.)
It may not seem like this really balances out. Not everyone spends everything they make, of course. Prudent people save money for the future. But meanwhile, people in trouble, or retired, or going through a change, or investing in their future (with education, for example) spend down their savings, or go into debt to buy a house or a car - and that offset winds up balancing out. Any dollar earned eventually gets spent somehow. The point is that unless savings rates are changing overall in the economy at large, the total amount produced and the total amount consumed winds up the same. Or as economists put it, an excess of supply in one market means there's an excess of demand somewhere else. The reason people don't buy X is that they'd rather buy Y.
Remember that point, especially the "unless".
It's not a perfect system, because we don't anticipate the future perfectly. Some companies don't sell enough, so they have layoffs or go bankrupt. But that (in a normal, non-recession economy) doesn't mean people are buying less, it means people want to buy something different than what's being sold. So that company goes under, and the people who were working for it go to work somewhere else where they're making stuff someone actually wants to buy. And so on. These "disruptions" are happening all the time in a healthy economy. If X isn't selling, people stop making as much X and go get hired to make more Y.
Also, in a healthy economy, you mostly want the government out of the picture (from an efficiency standpoint). There do exist market failures where the government has to intervene, there are some cases where the market doesn't appear to work well, and because of this there's thriving and vibrant debate between progressives and libertarians about where those lines are drawn and how much the government ought to step in. But most people agree that for most of the economy, most of the time, you let the market handle the generation and distribution of stuff, and it does this job, of producing what people want and providing it to them at a fair price, pretty well. (The progressive/libertarian debate about the size and scope of government is for another time. It doesn't actually enter into this.)
So what happens in a recession? Well, first off, sometimes something bad happens to trigger it -- perhaps interest rates are set too high for too long (to prevent inflation, which is yet another topic) so companies can't borrow and invest, or some bubble (stocks, housing, tech) bursts, or a war starts, or there's a major technological disruption causing more than the normal amount of layoffs to happen, or some sector of the economy partially collapses (e.g. the financial sector, or the automobile industry, or the banks), or some other country starts out-competing us, or whatever. And because of whatever it is, a lot of people lose their jobs. And then what can happen is that people in general, even the people still working, get scared. They still want to work, but they don't want to spend. They want to save more of their money, because they think they might need it later. They are less inclined to borrow and invest. Overall, savings goes up and spending goes down -- and this comes back to the point I made above, about production and consumption being the same.
Why is this bad? Because everybody still wants to work, and earn, as much as they did before (or even more, because they're more nervous and thus want more money to hang on to). Which means that overall, everybody wants to buy less than everybody produces.
And that can't happen. You can't have people making more stuff than people want to buy, because that means someone out there is making stuff that isn't selling, which means they can't pay their workers, which means there will be layoffs and bankrupt companies, and there is no new market elsewhere for that effort to move to.
So take a step back and look at the cause. When people save money and don't spend it, they are loaning money to the future. If one person does this but someone else is meanwhile spending money loaned from the past -- spending down their savings, or borrowing money to pay back later -- great! That's how it's supposed to work, and it all balances out (as above) because at any time there are people in all different situations and doing all different things.
But if the economy as a whole is saving money more than it did - everyone's putting off their big purchases for later, deciding not to buy a big-screen TV after all, or whatever - then there's an imbalance that can't be maintained. On its own, the way this corrects itself is very bad: when people as a whole aren't buying stuff (because the economy looks bad, and they're worried about their own future), companies can't sell as much product, so more people get laid off, so even fewer people are working, so everybody gets even more scared and spends even less.
This can, in the worst case, get worse and worse - it becomes a depression, aka a "deflationary spiral". It's what everyone is terrified will happen in a recession. It's what regularly happened to capitalist economies, most notably ours, up through the 1930s. It's also what a lot of us believe was only narrowly averted early in 2009.
What if companies save money by lowering wages rather than laying people off? The problem is still that they're overproducing. People don't respond to lower wages by becoming less productive; if anything, people tend to respond to lower wages by working longer hours, taking second jobs, and in general trying to produce still more. It doesn't make people feel better about the economy for them to be earning less - if they can't find a way to make more money, they'll cut back more on their spending, because dropping wages makes people just as nervous as dropping employment. And they're right, too - if people everywhere are cutting back even more, demand keeps dropping, and the same deflationary spiral happens as if more people were being laid off.
So what does the government do when faced with a recession? Well, normally, the big thing a modern government does when a recession starts is have the central bank (the Fed) cut interest rates. That makes it easier to get credit: investors and entrepreneurs can then borrow money at better rates. (From whom do investors borrow? From money in a bank somewhere that someone is saving against future spending -- they're borrowing from someone else's future. Remember that - borrowing is done against future spending, not present spending.)
Why does easier credit (lower interest rates) encourage investment? Because investment has two costs: interest on the money, and risk that the investment won't pay off, and those two costs are added together. If the cost of borrowing money goes down, investments that weren't worth it before (interest rate plus risk) are now worth the risk -- so investors are more willing to expand or start new businesses if the cost of borrowing the money for it drops. And those new or expanded businesses will employ additional people. And when more people are employed, they have money to spend -- i.e. demand starts increasing overall -- and when demand is increasing, investment becomes a better risk, so more investment happens, so even people get hired to meet that demand and thus have jobs, and then everyone starts feeling better about the economy, and spends more of that saved-up money they'd been waiting to spend, and everything gets even better. And a lot of those entrepreneurial ventures even succeed, and we get more and better goodies out of it. (And eventually this can heat up too much, and inflation can happen, which as I say is a different topic, and which leads to the Fed increasing interest rates to make borrowing harder, so it can cool down.)
And those lowered interest rates are how we got out of most of the recessions from the 50s through the 90s. But with the Great Recession of 2007-2009 (and to an extent the one before it, in 2001), interest rates were already really low going into the recession, and the Fed couldn't cut them any more... and the favorable environment for investment wasn't actually producing investment. Getting more products out there wouldn't have helped, and investors saw it: it's not that the wrong products are out there, it's that no product is the right product if people want money more than they want stuff money can buy. Everyone (overall) was loaning money to the future. There was plenty of money out there available for entrepreneurs and investors to borrow, but entrepreneurs and investors looked at the national mood and the national economy, and they didn't see a lot of untapped markets - they didn't see anything people would be willing to part with their savings to buy more of. Because people were scared of the economic situation, and trying to save whatever they could.
And even though the recession's technically been over for a while, growth and employment are still sputtering. For as long as unemployment remains high and the economy overall looks crappy, people will keep holding off on big and optional purchases, and the economy will stay crappy and unemployment will stay high.
So what's left for the government to do?
What's left is borrowing money from the future, to offset the imbalance in the rest of the economy. The government runs a deficit and spends money it doesn't have yet -- exactly like lowering interest rates would encourage entrepreneurs to do, if the economy were only in a normal recession. Why does that work when investment doesn't? Because the government doesn't depend on making a profit, so its "risk" calculation doesn't depend on current demand. The government might spend some of this borrowed money to buy certain products out in the market (directly increasing demand), or just give it to people to spend via welfare (indirectly increasing demand by getting money into peoples' pockets); but in the best case it spends it employing people to build infrastructure: repair roads, do basic and applied research, build bridges and power plants and fast-internet backbones and schools and hospitals. In other words, you make government do the stuff government is supposed to do anyway (if you're not an arch-conservative/libertarian), but you do more of it, because people need jobs -- and once people have jobs, they will have money to spend, and when they see that other people have jobs too, they'll feel better about spending it, and they'll spend it on the goods and services that the rest of the economy is producing and trying to sell -- which means the rest of the economy can hire people, people will feel better, people will spend more, and it spirals up instead of down, until we reach full production capacity and full employment.
At which point the government infrastructure projects get finished, and those people go to work in the now-vibrant private sector.
That's why governments are supposed to run big deficits during severe recessions. And it's why they're not supposed to run deficits during normal economic expansion - because then they're competing with private industry and private investment for the available capital out there for loan, and in normal times private industry does a more efficient job of producing products people actually want to buy.