This Recovery Will Be Difficult

January 12, 2009
The U.S. economy is quite capable of recovering from a recession quickly and with little damage without any government interference.  Left alone, free markets rapidly adjust prices and reallocate resources in response to economic conditions.  Government meddling intended to prevent the unavoidable adjustments, such as trying to artificially stem the tide of rising unemployment with massive government spending and preventing the failure of poorly managed companies or those that do not produce the goods and services consumers want, will at best only delay what must eventually take place in a truly free marketplace.

Recovering from the current recession will be more difficult than the two most recent downturns in 1990/91 and 2001 because of government interference.  The unprecedented bailout of the banking and financial sectors last year has already ensured that this recession will be more severe and last longer than it otherwise would have been by delaying inevitable asset value write downs and increasing uncertainty.  In addition, the massive trillion dollar stimulus bill that is currently being planned will do little or nothing to help the economy recover, but it will provide an opportunity to permanently increase the size of the federal government and fund pork barrel projects that would never pass on their own merits.

Despite all of the fear mongering about this being the worst financial crisis since the Great Depression, it is just not true.  So far, unemployment in this recession has not yet reached the levels seen in 1991, much less approached the double-digit levels of the early 1980’s.  The Congressional Budget Office (CBO) estimates that unemployment will peak at 9%, painful but hardly a catastrophe worthy of completely abandoning capitalism and free market principles.  Inflation is still low, but that will change after the gigantic spending spree being planned.  Interest rates are also low, but that too will change as borrowing by the government begins crowding out the private sector in competition for capital.  Foreclosures and delinquency rates on home mortgages are and will continue to be an issue until home values stabilize, which probably cannot happen until the banking and financial sector finally accept their losses and write down mortgage values, although foreclosures did peak in August last year and have been slowly declining since.

Consumer confidence is the key to turning around the economy.   Businesses and consumers will not increase spending if they are constantly being told that things are terrible and only going to get worse.  President Bush was widely derided by critics for espousing optimism and telling consumers to go shopping after 9/11.  In the midst of a recession and not knowing what the full impacts of the terror attacks would be on the economy, that was an appropriate response that actually hastened the economic recovery.  The incoming administration could learn a lesson from that and employ a similar strategy to help restore confidence.  The irresponsible rhetoric being used to talk the economy down with doom and gloom comparisons to the depression in order to pass bad legislation is just propaganda to generate support for a big government political ideology.  But as Rahm Emanuel, the incoming President's Chief of Staff, said back in November "Rule one: Never allow a crisis to go to waste."

Since it appears that the incoming administration thinks it must do something, policy responses to past recessions are a good indication of what works and what doesn't. The government really only has two economic tools to work with in response to a recession; fiscal policy (taxes and spending) and monetary policy (money supply and interest rates).  Our country has endured six recessions since 1971 with various combinations of fiscal and monetary policy changes being used in an attempt to lessen their severity and length (recessions prior to 1971 are not directly comparable since until that point we were under the gold standard).  The consensus among economists is that looser monetary policies, increasing the money supply and lowering interest rates, are the most effective tools to use since they can be quickly implemented and quickly reversed if inflation or other problems develop.  Expansionist fiscal policies that significantly increase the structural deficit are generally regarded as less effective in the short-term and detrimental over the long-term.

Among advocates of the use of expansionist fiscal policies, permanent tax rate cuts are regarded as much more efficient and effective than spending increases or one-time tax rebates.  That is because tax rate cuts give consumers and/or businesses more disposable income immediately after taking effect and allow the free market to decide how to make the most efficient use of the additional capital over the long term.  In contrast, large government spending increases often take considerable time to work their way into the economy and new or expanded programs are almost impossible to reverse once they have begun.  That eventually leads to the need for large tax increases at some point to narrow the revenue shortfall, which increases uncertainty and doubt about the future.  Additionally, consumers and businesses will only spend income on goods and services they want and need while government spending is much more wasteful, which helps to prop up companies and industries that might not otherwise survive in a free marketplace.