Mitigating recession: how far should government policy go?

Among Keynesian economists, it is generally accepted that governments should intervene in the economy to manage the business cycle using fiscal and monetary policy as tools of macroeconomic management. During the post-war boom until the 1970s, full employment used to be considered not only desirable but also feasible. Faced with rising inflation towards what proved to be the end of this boom, governments were influenced by monetarist and new classical economists and the Keynesian social-democratic consensus was overturned, particularly in the US and UK, but also across the rest of the rich world. This was part of a general turn away from state intervention, including in the developing world, and various forms of ‘neo-liberalism’ became the new policy orthodoxy.

With the advent of the Great Recession, governments temporarily turned once again to expansionary fiscal policies (Keynes was back!), alongside expansionary monetary policies. The latter was sustained to the present day, with interest rates at record lows and central banks engaging in ‘quantitative easing’ to try to overcome deflation. The former was abandoned to various degrees with the turn to austerity, with unfavourable results, particularly in Europe, but also in the US with much political wrangling over the ‘fiscal cliff’.

Austrian economists and, strangely, some Marxists, in contrast to the Keynesians, are less inclined to think that such expansionary policies can work to bring economies out of recession. Austrians tend to blame government policy for booms and suggest that recession is needed to purge misallocated capital from the system. Only then, they claim, can recovery proceed efficiently.

Some Marxists have a similar view, and focus on the role of the economy-wide rate of private sector profit. An economic downturn which leads to the depreciation of capital, capital scrapping and job losses may in their view be necessary to restore a rate of profit which provides the funds needed for new investment. It is investment, say these Marxists, which drives economic growth. Macroeconomic policies which stimulate demand will prevent the industrial restructuring which restores a healthy rate of profit, painful though this is. The solution to this dilemma is to abandon capitalism for socialism and central planning. By contrast, the Austrians stick with capitalism and argue for less interventionist governments and financial sector reform so that the excessive boom does not occur in the first place.

Richard Koo has argued, in his reassessment of macroeconomics, that there are two kinds of recessions: ordinary and ‘balance sheet’. In normal times, economies go through growth fluctuations and monetary policy should operate to balance saving and investment over the cycle. In these times, firms aim to maximise profits. However, in a balance sheet recession, which takes place following a major asset price boom and subsequent collapse, firms and households find that their assets are worth less than their liabilities and move to save and pay down accumulated debt. This will happen even if interest rates fall to very low levels. In this type of recession, Koo argues, fiscal policy should be used to absorb private sector savings, which would otherwise go unspent and drag the economy into deep recession. Government borrowing will in this way prevent economic disaster and help firms and households to repair their balance sheets. So in Koo’s world, fiscal policy should be used only in a balance sheet recession. In the latter, the vast majority of private sector agents are saving and paying down debt even with very low interest rates. They have moved from maximising profits to minimising debt. Of course, there may be borderline cases and I would argue that defining a balance sheet recession may be a matter of degree, so that fiscal policy could be needed more often than Koo suggests. Wynne Godley, the late post-Keynesian economist, argued that the private sector (firms and households) tends to run an overall financial surplus on average over the economic cycle, so that a budget deficit is needed on average to absorb private savings and maintain growth and employment. This is an empirical matter which it would be useful to study. Both Godley and Koo are in agreement that in a deep recession, government borrowing is needed to sustain growth or at least to mitigate the downturn.

So who is right? How far should governments go to manage the economic cycle? I do not share the Austrian’s view that economic booms and busts are generally the fault of governments, although they can certainly make the situation worse through misguided intervention. What about the Marxists described above? I have discussed their ideas on this blog before and I find it quite persuasive that industrial restructuring to restore the rate of profit may be necessary. A downturn can lead to weaker firms going bust or being taken over by stronger firms, laying the foundations for future expansion. This can happen at any point in the cycle, although clearly it will be more common during a recession. Does this mean that expansionary monetary and fiscal policies can harm future prospects? This may be the case in Koo’s ‘normal’ recession when most firms are still attempting to maximise profits. In his balance sheet recession, rigid adherence to balanced government budgets will generally make such a recession far worse. Koo’s argument is that when the majority of the private sector discovers that they have over-leveraged in the boom, they will have learnt their lesson to some degree and do not need to be punished further. In addition, modern democracies create a pressure for governments to be seen to be doing something to improve the lot of citizens. This is not always a good thing, as it may lead to misguided policies. However, the mass unemployment and plunging living standards that occurred in the Great Depression of the 1930s led to the rise of extremist parties in Europe, with horrific consequences. Hitler’s policies of rearmament restored full employment and prosperity to Germany, but no-one would argue that this was desirable. Surely it would have been better for politicians to have prevented these events through earlier positive interventions.

So I would argue that government policies to support demand may be needed especially to prevent calamitous falls in output and employment during a balance sheet recession. What is missing from this is a discussion of industrial policy. Economists who focus on macroeconomics usually ignore industrial policy, particularly one which enables the restructuring of the economy over time, which is a characteristic of capitalism. I will not go into detail on such policies here, but a proper treatment of industrial policy, which can take many forms, must be part of any long-term strategy to sustain prosperity. Also important is a welfare state which helps to sustain consumption, reduce inequality, and which allows for and aims to mitigate the effects of periodic unemployment and poverty which are a feature of the economic cycle. The latter cannot be prevented however enlightened macroeconomic policy might prove to be!


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