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By Steve Levy

Recession causes and cures

Uploaded: Apr 15, 2009

We usually identify and measure recessions by (1) the amount of job losses, (2) the reduction in the national production of goods and services (a decline in real gross domestic product, and (3) the result of these first two events: a sharp rise in unemployment rates. A recession is a prolonged period of economic downturn.

Why recessions happen

Recessions occur when there is a prolonged drop in spending. When total spending in the economy declines, there is not enough demand to keep everyone employed and as sales and production drop companies begin to lay off workers -- there are not enough customers to keep everyone employed.

The anatomy of the current recession

The current recession started when there was a broad recognition that home prices were far above normal levels and that many borrowers had bought homes they could not now afford. The combination of these events triggered a sharp drop in home prices and foreclosures that is still continuing. These two events also created a tightening of home-lending criteria and caused a huge decline in home construction and related jobs and spending.

The next event was the realization that banks and other financial institutions were severely affected by the losses in home values and were holding loans that would never be repaid. The housing downturn became a financial-sector crisis as financial institutions faced large loan losses. The nation saw mergers, bankruptcies and federal takeovers to try and stabilize the banking sector.

These events resulted in a loss of confidence and decline in the stock market. The large loss of wealth in home and portfolio values caused a slowdown in consumer spending. At the same time that our domestic economy was turning down, economies all around the world were slowing, which has led to a sharp decline in U.S. exports -- another spending sector to turn down.

Currently these declines in spending are feeding on each other creating large continuing job losses and great uncertainty and fear and further layoffs as businesses are preparing for lower sales in 2009.

What is different about this recession?

This recession includes a substantial loss of wealth, continuing uncertainty in where the bottom of housing prices and foreclosures lies, and uncertainty about the solvency and future of our banking system.

This is why President Obama has characterized our efforts to reverse the economy's downturn as a three-legged stool: (1) stimulus spending to boost demand and create jobs, (2) new efforts to stem home foreclosures, and (3) programs to bring stability to the banking system.

All three pieces must succeed.

The economics of stimulus efforts to fight recessions

Since recessions are caused by a drop in spending, the antidotes are policies designed to boost spending.

As President Obama said with some exasperation recently (my paraphrase), "Some people complain that the stimulus bill is a spending bill. What do they think stimulus is if not programs to increase spending?"

Actually there is no disagreement about the goal of increasing spending. The political dispute is about the way to increase spending. The federal government has the big anti-recession arsenal. There are three main anti-recession weapons: (1) interest rate cuts, (2) tax cuts and (3) direct government spending.

Interest-rate and tax cuts are designed to provide incentives to increase private-sector spending by households and businesses. Direct government spending makes government the "customer" who will increase spending to restore production and jobs.

The theory behind interest-rate cuts is to lower the cost of interest to consumers and businesses. If interest rates are lower the cost of buying a home or car or investing in a new plant will be lower. In addition payments on credit card and other consumer debt will be lower.

The theory behind tax-rate cuts is that (1) they increase income for consumers and businesses and (2) they increase the incentive to work and invest.

The theory behind direct government spending as stimulus is (1) we can be sure that all the money will be spent and (2) we can target the money to "deserving" areas, such as increasing unemployment benefits and infrastructure investments and minimizing the reduction in state and local education and health spending.

One problem the administration faces is that tax cuts may not be spent by families and businesses. If the objective is to provide immediate support for spending, this poses a problem for tax cuts as indicated by behavior from the 2008 tax cuts.

Tax cuts directed at lower-income families are likely to be fully spent, and that was the direction of the stimulus package. Business and consumer tax credits for spending now (buy a car or home or invest in new equipment right now) were included, but general tax cuts for businesses were excluded on the theory that most large businesses would not expand capacity when they were closing factories and laying off staff because there was a shortage of customers.

That leaves a more important role for direct government spending (government as the customer of last resort).

The president argues that targeted direct government spending can do "double duty" for the country. It has a short-term impact of job creation plus a longer-term impact of creating a benefit for the future. For example, infrastructure investment creates jobs while creating an asset for the future: a bridge, water system, more energy-efficient buildings, more technologically equiipped schools or a national broadband network.

In addition, direct government spending is the only way to prevent cuts in state and local programs for education and health care as state and local governments cannot maintain spending without raising taxes. It is a flaw in our social contract about safety-net spending that the federal government is supposed to pass emergency aid for programs such as food stamps and unemployment insurance while state and local governments must cut back on safety-net spending when it is most needed.

Beyond the stimulus bill

Beyond the stimulus bill itself the other two "legs of the recovery stool" have been defined and are starting to be implemented.

One of the major housing initiatives offers the opportunity to refinance home loans to millions of existing homeowners. The lower interest rates act like a tax cut in the sense that homeowners who can refinance have $200 to $400 more per month to spend. There is a second plan for loan modifications for troubled homeowners and that initiative will increase spendable income for homeowners who qualify as well as reduce the number of foreclosures that the housing market has to absorb.

There are also initiatives to support stability in the financial system and provide financial support and guarantees for lending and for the purchase of so-called "toxic assets" by private investors from banks so that banks have more capacity to lend.

All three components are needed given the size of the downturn and the major challenges remaining in the housing and banking sectors.

I have written another blog about how to assess our progress in turning the economy around.

The thread about the blog

"Anna" started a thread about what readers thought of the last blog I wrote. Most responders were unhappy about being asked to register and having their comments reviewed, as is already currently supposed to be done by the editors. Now editors take down inappropriate material after it is posted. In a moderated blog editors would delete inappropriate material before it is posted. There are no issues of censorship. It is simply about when the current rules are applied. But for now the Weekly can't offer the moderated blog so I am asking posters on my blog to register before they post.

Registrants are asked for their name, e-mail, gender, age and zip code and other items on a voluntary basis -- things everyone gets asked regularly by businesses to better understand consumer profiles and to contact customers. We give this information all the time. So I don't have to guess at why this requirement bothers people I ask readers to tell us their reasons. I value Ohlone Par's comments and don't understand why registration seems so onerous.

Registrants are encouraged to post under their real name but are allowed to post anonymously.

Also I am interested in why people complain if the Weekly does what their guidelines ask for from participants in the Weekly's Terms of Use.

Anna raised some interesting questions, which I would be happy to answer if posted respectfully in response to the blog. "Adam" and "Resident" made posts that were completely appropriate and welcome on the blog. So register up or let us all know more clearly what the barriers are. I don't have access to the registration information or the ability to edit the blog myself.