Recession

Making the Most of the Next Recession

Another downturn is inevitable. What matters is how we respond.

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The U.S. economy is teetering on the edge of a cliff. The federal government's mounting debt combined with slow economic growth and exploding entitlement spending all but guarantee a recession is in our near future.

That isn't necessarily a bad thing. Recessions are part of the natural economic cycle. In the best-case scenario, they restore balance to an economy by "cleansing out the misuses of labor and capital," says John Tamny, senior fellow in economics at Reason Foundation. "Recessions, while painful, are the happy sign that growth is on the way."

Unfortunately, the upsides of recessions can be wiped out by bad government policies that prevent the economy from making needed adjustments. What's more, many policies aimed at "moderating" recessions can lead to excesses in the economy that make the next downturn even worse. Instead of redirecting resources to more efficient uses, these measures often cause a doubling down of investment into wasteful endeavors that produce little in the way of surplus for society.

Writing for The New York Times in December 2008, George Mason University economist Tyler Cowen explained how the 1998 bailout of Long-Term Capital Management, a hedge fund, harkened the Great Recession of 2007–09. It's true that move prevented large disruptions in capital markets that would have made the situation more painful for some in the late '90s. However, Cowen wrote, "with the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed—as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed."

Government produced a sense of immunity for many in the financial sector, thus contributing to the biggest financial crisis since the 1930s. And this is but one example of government interventions that are aimed at helping ease economic problems in the near term but get in the way of necessary reallocations of resources and set the economy up for even bigger problems in the future.

Thankfully, there are things that can be done to help us better weather the next economic downturn and achieve faster growth in its aftermath. For starters, we should be working to restore flexibility in the economy, reduce uncertainty, and bring down our public debt.

Greater flexibility in prices, wages, and the ability to hire and fire or start and dissolve businesses means an economy better able to avoid (or at least minimize) the consequences of a recession. Minimum wage laws and long-term unemployment benefits, while well-intentioned, actually make the labor market less flexible and slow down the recovery.

Similarly well-intentioned policies that try to stop prices from falling simply shift the correction to the "quantity" side from the "price" side, which often creates more dramatic consequences. Imagine what would have happened if the feds during the Great Recession had banned people from selling their homes for less than they paid for them. The answer is clear: Demand for houses would have plummeted; no one wants to buy something that costs more than it's worth. Taking a loss on real estate is no fun, of course, but not being able to get out of a bad investment is far worse. Sometimes, prices need to come down in order to give everyone a fresh start.

Besides allowing prices to adjust organically, the government must learn to stop injecting uncertainty into the economy. Bob Higgs, a senior fellow in political economy at the Independent Institute, has shown that "regime uncertainty"—which happens when there's a widespread inability to form confident expectations about how private property rights will be treated in the future—dampens investment. When people think government officials might decide to seize what they have, they generally choose to remain on the sidelines, hoarding their wealth, putting it only in low-risk, low-return, short-term investments, or consuming it now when they know they can. But during a recession, less investment translates into less recovery.

What can be done to end regime uncertainty? "As long as the rulers possess great discretionary power, the peasants will be subject to all the uncertainties created by the vagaries of the rulers' exertion of their power," Higgs says. "A long season of 'do-nothing' government would help a great deal."

Uncertainty is also created by regulation. Take Dodd-Frank, the most significant reform to U.S. financial regulations in over 70 years, which was enacted in the aftermath of the last decade's crisis. Although the law has been on the books since 2010, the federal agencies are nowhere near finished writing all the rules associated with the legislation. The sheer vagueness of the situation forces U.S. businesses to spend even more time and money trying to figure out how on Earth to stay in compliance. The enormous uncertainty that this law created has paralyzed entrepreneurship and job creation, exacerbating the very crisis it was aimed at addressing.

Uncertainty is also created by central banks' ad hoc and discretionary policies. The Federal Reserve's repeated attempts to offset consumers' desire to hold on to their money rather than spend it have created major distortions to the capital markets. This imposes serious costs on the economy. Economists, including the Mercatus Center's Scott Sumner, argue that if the government adopted a credible, rules-based monetary policy—promising to raise interest rates by a set amount, no matter what, as inflation increases, for example—it would send a clear signal that would reduce uncertainty and weaken the risk of recessions.

But the truth is that there isn't much the Fed could or should do to fight recessions in the first place. If there is such a thing as a monetary policy that will stimulate growth, the Reason Foundation's Tamny argues "it will come from the U.S. Treasury publicly endorsing a strong and stable dollar." He thinks this will cause a surge in investments into the U.S. from around the world.

Ultimately, though, the most important thing we can do to keep the next recession from wreaking catastrophic damage is to reduce the national debt. According to the St. Louis Federal Reserve Bank, the total public debt is currently above 105 percent of America's gross domestic product. To state that more clearly, the government owes more in bills it can't pay than our entire economy will produce this year. That is a problem, because too much debt makes it hard to respond to emergencies when they do arise.

The way forward is clear: Economists don't agree on much, but the scholarly literature consistently finds that spending cuts are more likely than tax increases to lead to lasting debt reduction. A common worry is that cutting expenditures might reduce overall demand for goods and services and thrust us into an economic slump. But as Harvard economist Alberto Alesina has pointed out, reducing spending is more likely to be associated with economic expansions than recessions. This makes intuitive sense: Fiscal adjustments based on spending cuts demonstrate that a country is serious about getting its house in order. That's an important signal when the economy is strong and an even more important one when it's weak. Higher taxes, on the other hand, nearly always get eaten up through more new spending and do nothing to combat the underlying problem of America's indebtedness.

No amount of fiddling with economic policy can eliminate the possibility of future recessions. The important thing is reacting to them in ways that make us stronger on the other side.

NEXT: Brickbat: Land of the Free

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  1. FU cut austerity!

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  2. The enormous uncertainty that this law created has paralyzed entrepreneurship and job creation, exacerbating the very crisis it was aimed at addressing.

    Well, our Compliance Department is growing by leaps and bounds… sure, the actual business isn’t, but hey,guvmint created jerbs!

  3. “Thankfully, there are things that can be done to help us better weather the next economic downturn and achieve faster growth in its aftermath.”

    Yeah, but who thinks that is going to happen?

    1. You mean you don’t trust Hillary or The Donald on that?

  4. Ultimately, though, the most important thing we can do to keep the next recession from wreaking catastrophic damage is to reduce the national debt. According to the St. Louis Federal Reserve Bank, the total public debt is currently above 105 percent of America’s gross domestic product. To state that more clearly, the government owes more in bills it can’t pay than our entire economy will produce this year. That is a problem, because too much debt makes it hard to respond to emergencies when they do arise.

    Pah! Japan’s is over 200% of GDP!! Plenty of room left – raise the roof!!!

    http://www.tradingeconomics.co…..ebt-to-gdp

  5. Ultimately, though, the most important thing we can do to keep the next recession from wreaking catastrophic damage is to reduce the national debt.

    Veronique and Co.: This line about the national debt must be abandoned. It’s making conservatives and libertarians look like economic idiots (though progressives also believe the national debt is a problem, they don’t dwell on it, because it’s convenient for them to ignore it, their very raison d’etre being to spend money on their precious programs and otherwise redistribute wealth).

    You are entirely wrong on this (you too Nick!). The US national debt has *nothing in common* with household debt, and other types of “debt” with which we are all very familiar. The name should even be changed to reflect this fact. More accurate would be “national aggregate savings” or “national net financial assets.”

    1. cont’d…

      The national debt is equal (to the penny!) to national aggregate savings. Because people (very rationally) have a desire to save, the government must create more money than is needed to clear the goods from the shelves of our national supermarket (to introduce a convenient analogy) on an annual basis. We call this the federal debt.

      The amount of money that must exist in order for a functioning economy is proportional to the size of that economy, and that means that in order for the economy to expand, the national debt must increase every year – assuming that people want to save some of what they earn.

      It’s easy to see at a macro level that if you “pay down the national debt” you take money (through taxes, for example) from the citizenry and effectively destroy it. Similarly, if you expand the national debt by running a deficit, you create net financial assets (grandma gets an extra $100 in her checking account, or whatever).

      This point is crucial. We need to spend our efforts rolling back government regulations and other affronts to liberty, *not* arguing that we need to pay down the national debt, which would cause a recession or a depression.

      1. you left off the /sarcasm tag

      2. Dumb post of the day. Really, really, icredibly, dumb….

        1. Ok, tell me what’s wrong about it, smart guy.

          Sometimes you have to accept that other people know more about something (especially a technical field) than you do, and sometimes you have to accept that what your ideology tells must be true you isn’t the truth.

          Every dollar added to deficit in a budget is one dollar of net financial assets created. Paying down the debt is extracting net financial assets and destroying it.

          And no, we’re not borrowing from China.

      3. Wow. You know in our BS fiat system they could just issue more currency directly into the hands of the public to achieve what you are talking about right? They WOULD have to tax people more to spend at current levels without running a deficit, which is a feature not a bug. It would force them to raise taxes, which would piss people off, which would make them more likely to keep spending in check to avoid pissing the people off. Far better than the current “shadow tax” of deficit spending, which also leaves us beholden to those that buy our debt.

        1. Yes, that is often referred to as a “helicopter drop” and we do it in forms more subtle than just dropping cash out of a helicopter. But think about it – wouldn’t that be a better stimulus than earmarking the money for one of the Democrats’ pet projects?

          We only have income tax to prevent inflation – not to “raise revenue.” The government doesn’t need to raise revenue, since it is a sovereign issuer of its own currency.

  6. Poor Veronique thinks the Great Recession is over.

    All the real indicators hidden by the current government are there. High true unemployment, bigger than normal state-to-state movement for jobs, lower spending on typical essentials and lower disposable income spending.

  7. Recessions are part of the business cycle, which is caused by fractional reserve banking, most often backstopped by a central bank. Unless 100% reserve banking is instituted, recessions will be forever with us…

  8. Short the market–especially currency derivatives–whenever you know the Looter Kleptocracy is about to issue another Anti-Money Laundering and Prohibitionist Directive 10-289. Short foreign markets whenever the State Department gloats that it suckered some Bandana Republic or Medieval Dictatorship into robbing and shooting its own people over foreign sumptuary laws. Finance, like handcuffs and asset forfeiture, is all on the wrist.

  9. I would be ok with another housing bust on account of the fact that I would hopefully be able to scoop up a house or two before things “recovered” again. I just barely missed the train last time, and Seattle real estate has got INSANE.

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  11. Nah I bet we can agress our way out of this recession. That makes sense both by first principles and efficacy.

  12. Nah I bet we can agress our way out of this recession. That makes sense both by first principles and efficacy.

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