How Does an Economy Turnaround?

How does an economy turnaround? That is the big question in Washington D.C. and around the country. Some say it is infrastructure spending while others say it is tax cuts. Usually the entire debate is focused around what will stimulate the economy enough to lift it out of the recession we are in. Of course this assumes the government must do something to turn the economy around, and that without government action, the economy would simply continue in a downward spiral. At least that is how a lot of the discussion goes.

Of course the flip side of the question is how does an economy go into a recession in the first place? If the question is asked at all, the answer usually finds a nefarious actor to blame. During the recent political campaigns, the candidates usually blamed greedy Wall Street types. Many blamed the former President and his political party - usually ignoring that the other political party controlled the Congress since 2007 - which actually sets the federal budget and makes law. It sort of begs the question whether a nefarious actor has to be found to blame at all for the variations of the economy. Do those nefarious actors get credit when the economy does well? Usually not. Besides, different parts of the political spectrum have their own nefarious actors to blame, lambast, and ridicule. It usually only adds to the acrimony in politics rather than help to solve any problems.

Another way to look at recessions, recovery from recessions, as well as expansions of the economy is the business cycle. Just as there are cycles for many things, including the seasons, there is a business cycle for an economy. In general, economies tend to expand for a certain time, peak, then start to contract, bottom, and start recovering. Sometimes the cycles are longer and sometimes they are shorter. Usually when economies are expanding, they reach a point when they have outpaced the capacity of that economy to continue expanding, and the economy has to contract. It usually contracts until the forces in that economy are in a state to expand again, which is usually called a recovery. Hopefully, the economy continues to rise overall from one cycle to the next. The business cycle usually occurs without any action from the government. This means the government does not have to do anything for an economy to recover. It usually happens all on its own.

Of course politicians do not like to say this. They are elected to do something, especially when an economy takes a downturn. They like to indulge in big talk about how they are going to take action to turn the economy around, even though it will likely do so all on its own. I think the government can help in an economic downturn, as long as the actions it undertakes helps the recovery that usually already occurs all on its own. The government can also help those hurt by the downturn, since the churches, charitable organization, communities and families who usually help are also hurting. This is similar to the field of medicine where the best cures work with the natural ability of the body to heal itself. What I worry about is that action by the government can work against the natural ability of the economy to recover from a downturn and thereby extend the downturn -possibly even turning a recession into a depression, which is simply an extended recession.

A lot of scholars are reexamining the Great Depression to determine if this happened. They are examining actions by the government under both President Hoover and President Roosevelt to determine whether government action extended the Recession of 1929-1930 into the Great Depression which did not end until the start of World War II. I think this is a worthwhile study that is very relevant to our current situation. I will discuss their research and conclusions in a following post, perhaps the next one, though I have wanted to do one about Out of the Silent Planet for a while.

Infrastructure Spending

Many currently advocate spending on infrastructure projects in order to recover our economy from the Recession it is in, and to prevent it from getting worse. Traditionally, States and local governments fund most infrastructure projects. I favor such spending by State and local government, often financed by government bonds. However, from a historical perspective, Federal infrastructure spending has not recovered an economy from an economic downturn. The Great Depression provides a classic example of this.

As the Recession started around 1930, the government under President Hoover, started spending more on infrastructure programs such as the Hoover Dam, among others. By 1932, government spending increased by 50%, a huge increase. However, this increased spending did not turn around the Recession, which then became the Great Depression.

When Franklin Roosevelt became President in 1933, he launched many infrastructure projects under various new federal programs. He increased federal spending even higher in an attempt to bring unemployment under control. Even with all that spending, unemployment never fell below around 15% until 1941, well into World War II - a rate we today would find an unacceptable tragedy.

1929 - 3.3% 1930 - 8.9% 1931 - 15.9% 1932 - 23.6% 1933 - 24.9% 1934 - 21.7% 1935 - 20.1% 1936 - 17.0% 1937 - 14.3% 1938 - 19.0% 1939 - 17.2% 1940 - 14.6% 1941 - 9.9% 1942 - 4.7%

There are other examples in history, including Japan in the 1990s which launched massive infrastructure spending to turn around its economy, only to wind up with massive yearly deficits, and an economic doldrum that was called The Lost Decade. There are several reasons why massive infrastructure spending does not turn an economy around. One of them is the lag time for infrastructure projects to get going, and to put money in the economy. The Congressional Budget Office yesterday published a preliminary report about the proposed infrastructure spending, and noted that most of it won't be spent and get into the economy before a recovery is already underway. We should be cautious before generating deep deficit spending using this approach to try to turn the economy around.

The Great Depression Again?

Lately, some compare our current recession to the Great Depression. Ben Bernanke, the Federal Reserve Chairman, and a student of the Great Depression, addressed this at the Austin Chamber of Commerce. He said there was no comparison between our economy and The Great Depression - where unemployment peaked at 25%, the GDP lost about one-third, about 50% of homes foreclosed, around 1 out of 3 banks failed, and the stock market lost about 90% of its value. In contrast current unemployment is at 7.2%, the GDP lost 0.5% in the 3rd Quarter, the stock market has lost about 40% of its value, and the foreclosure rate is around 1 percent. Even if unemployment becomes worse in the coming months, and GDP loss grows, it is unlikely we will reach Great Depression levels.

Others say it is the worst recession since The Great Depression. However, since the Great Depression, we have had 11 recessions according to the National Bureau of Economic Research (NBER). The worst unemployment during those recessions was a peak of 10.8% during the 1981-82 Recession. The worst quarter GDP loss was a 10.8% loss during the 1957-58 Recession. At the current moment, we are still over 3% away from the peak worst unemployment, and 10.3 % away from the worst GDP quarter loss. (See update.)

Yet others say our recession could become the worst one since the Great Depression. We don't know that yet, and it is speculation at this point to so predict. Those who do so mostly want to justify an extremely large government spending program to address the situation they claim. This doesn't mean we are not facing a serious situation, but overexageration of how bad it is does not help, and can make the situation worse as consumers hold back on spending and investors hold back on investing.

What is true is that we are in the worst financial crises since the Great Depression. We are still in the midst of a collapse of housing bubble, which has far reaching effects in our financial institutions, resulting in their collapse. In the Great Depression, the relatively new Federal Reserve failed to take action to save collapse of major financial institutions, which led to a run on many banks. The resulting decrease in the money supply helped to turn an initial recession into a great depression.

This time, both the Fed and the Treasury, with the help of TARP, have flooded financial institutions with money to keep them solvent and liquid. This should keep the recession from turning into a depression as in 1930, though more has to be done, which is why the 2nd part of TARP was approved. However, the current recession is not yet the worst recession since the Great Depression. Saying it is so just to justify large government spending programs is not true, at least not yet. Basing a large government spending program on this basis is less than honest. Those doing so most likely favor large government spending programs anyway. The problem is the proposals so far will increase the deficit to about a staggering $2 trillion dollars for this fiscal year, making any past deficit look almost trivial in comparison.