Does America need a recession?
Aug 23rd 2007
From The Economist print edition
An intriguing, if unpopular, thought
THE late Rudi Dornbusch, an economist at the Massachusetts Institute of
Technology, once remarked: “None of the post-war expansions died of old age.
They were all murdered by the Fed.” Every recession since 1945, with the
exception of the one in 2001, was preceded by a sharp rise in inflation that
forced the central bank to raise interest rates. But today's Federal Reserve
is no serial killer. It seems keener on blood transfusions than on
bloodletting.
When the Fed cut its discount rate on August 17th, it admitted for the first
time that the credit crunch could hurt the economy. The markets are betting
it will soon cut its main federal funds rate. Economists are arguing
vigorously about how much damage falling house prices and the subprime
mortgage crisis will do. But there is one question that is rarely asked: even
if a downturn is in the offing, should the Fed try to prevent it?
Most people think the question smacks of madness. According to received
wisdom, the Fed should not cut interest rates to bail out lenders and
investors, because this creates moral hazard and encourages greater
risk-taking; but if financial troubles harm spending and jobs the Fed should
immediately ease policy so long as inflation remains modest. Central bankers
should be guided by the “Taylor rule”—and set interest rates in response
to deviations in both output and inflation from desired levels.
A necessary evil
But should a central bank always try to avoid recessions? Some economists
argue that this could create a much wider form of moral hazard. If long
periods of uninterrupted expansions lead people to believe that the Fed can
prevent any future recession, consumers, firms, investors and borrowers will
be encouraged to take bigger risks, borrowing more and saving less. During
the past quarter century the American economy has been in recession for only
5% of the time, compared with 22% of the previous 25 years. Partly this is
due to welcome structural changes that have made the economy more stable. But
what if it is due to repeated injections of adrenaline every time the economy
slows?
Many of America's current financial troubles can be blamed on the mildness of
the 2001 recession after the dotcom bubble burst. After its longest unbroken
expansion in history, GDP did not even fall for two consecutive quarters, the
traditional definition of a recession. It is popularly argued that the
tameness of the downturn was the benign result of the American economy's
increased flexibility, better inventory control and the Fed's firmer grip on
inflation. But the economy also received the biggest monetary and fiscal
boost in its history. By slashing interest rates (by more than the Taylor
rule prescribed), the Fed encouraged a house-price boom which offset equity
losses and allowed households to take out bigger mortgages to prop up their
spending. And by sheer luck, tax cuts, planned when the economy was still
strong, inflated demand at exactly the right time.
Many hope that the Fed will now repeat the trick. Slashing interest rates
would help to prop up house prices and encourage households to keep borrowing
and spending. But after such a long binge, might the economy not benefit from
a cold shower? Contrary to popular wisdom, it is not a central bank's job to
prevent recession at any cost. Its task is to keep inflation down (helping
smooth out the economic cycle), to protect the financial system, and to
prevent a recession turning into a deep slump.
The economic and social costs of recession are painful: unemployment, lower
wages and profits, and bankruptcy. These cannot be dismissed lightly. But
there are also some purported benefits. Some economists believe that
recessions are a necessary feature of economic growth. Joseph Schumpeter
argued that recessions are a process of creative destruction in which
inefficient firms are weeded out. Only by allowing the “winds of creative
destruction” to blow freely could capital be released from dying firms to
new industries. Some evidence from cross-country studies suggests that
economies with higher output volatility tend to have slightly faster
productivity growth. Japan's zero interest rates allowed “zombie” companies
to survive in the 1990s. This depressed Japan's productivity growth, and the
excess capacity undercut the profits of other firms.
Another “benefit” of a recession is that it purges the excesses of the
previous boom, leaving the economy in a healthier state. The Fed's massive
easing after the dotcom bubble burst delayed this cleansing process and
simply replaced one bubble with another, leaving America's imbalances
(inadequate saving, excessive debt and a huge current-account deficit) in
place. A recession now would reduce America's trade gap as consumers would at
last be forced to trim their spending. Delaying the correction of past
excesses by pumping in more money and encouraging more borrowing is likely to
make the eventual correction more painful. The policy dilemma facing the Fed
may not be a choice of recession or no recession. It may be a choice between
a mild recession now and a nastier one later.
This does not mean that the Fed should follow the advice of Andrew Mellon,
the treasury secretary, after the 1929 crash: “liquidate labour, liquidate
stocks, liquidate the farmers, and liquidate real estate...It will purge the
rottenness out of the system.” America's output fell by 30% as the Fed sat
on its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's
chairman, will not make that mistake. Central banks must stop recessions from
turning into deep depressions. But it may be wrong to prevent them altogether.
Of course, even if a recession were in America's long-term economic interest,
it would be political suicide. A central banker who mentioned the idea might
soon be out of a job. But that should not stop undiplomatic economists asking
whether a recession once in a while might actually be a good thing.
--
He: I am not good enough for you.
She: But I am.
--
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