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A siren call to reverse recession

A siren call to reverse recession
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First Published: Sun, Jan 20 2008. 11 47 PM IST

Updated: Sun, Jan 20 2008. 11 46 PM IST
It seems difficult to find any good news in the economic data coming out of the US. First, subprime turmoil brought mounting losses in some large and important financial institutions. And now reports indicate that retail sales growth was the slowest in seven years during December and surveys show that the economic sentiments of American consumers are at a 15-year low.
To determine the best response to recessionary conditions, it is important to know what causes them. Unfortunately, there is no consensus among economists on business cycles. Nonetheless, one theory has consistently provided explanations for past recessions as well as the one that seems to be rearing its ugly head.
In simple terms, this view is that booms and busts do not arise from innate elements of a market economy. Indeed, business cycles are predictable and certain outcomes of central bank policies that lead to excessive provision of credit by an artificial lowering of interest rates.
(A counterintuitive element of this view is that booms are destructive while busts are a welcome cure for excess. Just like the drying out process experienced by an alcoholic, it is painful, but leads to a productive outcome. More on this later.)
Cheap credit sets off the first stage, often referred to as a boom. Therein, actors in sectors highly sensitive to interest rates mistakenly invest in capacity that cannot be sustained based on real economic conditions. Of particular importance is that the existing real amount of saving cannot accommodate the new spending on capital goods that is based on an inflated money supply.
Booms based upon cheap-credit expansions orchestrated by central banks are like pyramid schemes. Firms may be aware of a likely bust, but they have an incentive to invest early in the boom to earn substantial profits that might offset later losses.
The second stage, known as a bust or a recession, occurs when central banks begin to halt credit expansions by tightening monetary spigots to relieve inflationary pressures. Rising interest rates lead to retrenchment in the same interest-sensitive sectors that were induced to invest too much during the boom.
As the US economy struggles to work through a cycle created by irresponsible central bankers, there is a siren’s call to reverse the process with a “stimulus” package. Many tried-and-failed nostrums are being offered as policy initiatives, including lower interest rates combined with tax rebates and some additional government spending.
The underlying logic behind all these notions is that if insufficient spending is the cause of recessions then they can be averted by doing what ever is necessary to boost expenditures. A simple reality check readily shows the errors in this argument.
If consumption were the source of economic problems, it would be prudent for everyone to go on a spending binge. But this flies in the face of every sensible notion about how household budgets look to the future and avoid debt as much as feasible to restrain consumption. Surely, prudent family financing seeks to secure future prosperity by deferring consumption and saving as much as possible for the future. These funds are then available for others to apply towards investments that yield a solid rate of return.
Since economic logic is not suspended when shifting analysis from a family budget to a national one, it can be no different for a country at large. In the face of an economic slowdown, individuals and businesses are well advised and indeed are likely to save more. The rational response of individuals and businesses to spend less as a recession looms cannot be blamed for economic troubles of an unavoidable downturn.
While less consumer spending is not the cause of a recession, neither is it a signal of a dangerous long-term trend. As households and business save more so others can invest, they provide the foundation for a recovery that will occur after an ongoing correction.
Given the faulty economic logic that drives the arguments for a stimulus package, it should not be surprising that real life and experience prove that they cannot bring their promised results.
First, consider the impact of tax rebates. Political expediencies aside, tax rebates do not work in the real economic world. Tax rebates offer no encouragement for anyone to increase productivity and add nothing to wealth creation, both being prerequisites for growth. As it is, rebates will come like manna from heaven without any extra exertion towards working or saving or investing or creating new wealth.
Governments cannot give anything or spend unless funds are extracted from the pockets of taxpayers or by issuing debt that takes away from future taxpayers. And since rebates are derived from taxes or new borrowing that removes money from somewhere in the economy, they cannot create any new net spending power. What happens is merely redistribution from one activity or group of people to others.
While a “consensus” is forming that an economic stimulus package is necessary, solid theory and experience show that this approach to recession is deeply flawed. Attempts to use fiscal spending or rebates to prompt economic growth involve concocting a new, artificial mini-boom in hopes of offsetting problems created by the previous artificial boom!
(Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at theirview@livemint.com)
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First Published: Sun, Jan 20 2008. 11 47 PM IST