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Questions & Answers
William Hamlen Jr. is associate professor of finance and managerial economics in the School of Management.
What exactly is a recession?
There are a number of definitions for a recession. I prefer the more general definition that a recession occurs when, for several months or more, the economy falls below its full employment potential. It typically includes a rising unemployment rate, a decline in either the growth rate of, or the actual real GDP (the real value of what we’ve produced), and sometimes a fall in the consumer price index. Frequently a fall in stock prices can be associated with a recession, but since stock prices are very volatile and are frequently driven by speculation, they are a weaker signal of a recession.
What factors have contributed to the current downturn in the economy?
It’s a little premature to describe the economy as being in a “current downturn.” You might say that we’re on the verge of a likely slowdown. Modern economic theory, mixed with political realities, hasn’t been able to provide sufficient tools to prevent business cycles, but they are able to mitigate the severity of such cycles and to calm unwarranted fears. When you look at the long-term data, we’re moving right along acceptable trends for most aggregate measures and we have to accept the normal variations around the trend. That doesn’t make it any easier, of course, if you’re the one “downsized” in a short-term contraction.
So why are there normal business cycles? We have experienced an expansion since 2001 and now are facing a possible slowdown. Business cycles are due to imperfect information. When prices are rising in some economic sector, there are profits to be made through buying low and selling high. This speculative motive causes prices to be bid up beyond their sustainable levels. If there was perfect information, this wouldn’t happen. Add to this speculative motive the fact that individuals possess varying degrees of ability to manage assets and you can see why the economy cycles above and below the average growth path.
The current economic expansion and subsequent contraction emanated in the mortgage market. New instruments were developed that allowed for the diversification of risk by banking institutions holding mortgages. Modern techniques in finance have provided increasingly complex innovations for diversifying financial risk. Nevertheless, as we diversify risk so that each is exposed to less risk, we encourage an overall increase in risk-taking. But risk will have its day, or it wouldn’t be risk. In this case, large numbers of new mortgages were offered to individuals and households that could not withstand even the slightest amount of downturn in their expected incomes. In addition, some of the cheap mortgages were used to purchase homes for speculative gains. This further fueled the unsustainable rise in housing prices. When mortgage payments began to default and housing prices began to fall, some of the large financial institutions holding these mortgages realized too late that they weren’t as insulated from risk as they had thought. From the perspective of the rest of the economy, it meant that fewer houses would be built in the near future, and less credit would likely be available for even worthy investments. All of these events introduced fear that the U.S. economy was headed for a recession. Stock markets around the world began to overreact to the prospects of a U.S. recession, forcing the Federal Reserve to call an emergency meeting to reduce the federal funds rate.
Recessions occur when there is a drop in the aggregate demand, relative to the supply of goods and services. As long as there is a central bank, such as our Federal Reserve Bank, one obvious way to stimulate demand is through “monetary policy.” Increasing the money supply reduces interest rates and increases the borrowing of funds for investment purposes, including the construction of new homes. Beginning with John M. Keynes (1936), there also has been “fiscal policy.” This entails either increased government deficit spending to directly stimulate demand or one-time tax cuts to stimulate consumer demand. It works through the “Keynesian multiplier,” which means that each new dollar spent leads to multiple increases in income as consumers pass on some of their new income to others when they make purchases. Keynes recommended fiscal policy for times when monetary policy seemed ineffective. Today, those of the liberal-Democrat persuasion prefer fiscal policy to monetary policy because they believe that the infusion of funds can be directed toward lower-income households, whereas monetary policy is viewed as benefiting the higher income owners of businesses. Those of the conservative-Republican persuasion tend to prefer monetary policy since only business investment leads to the long-run expansion of the nation’s capital stock that, in turn, makes us all more productive. The current stimulus proposal is a compromise between these views. It provides one-time tax cuts not only to consumers, but also to businesses, with the hope that the latter will result in the desired long-run formation of capital stock.
The fear that consumers who receive tax breaks won’t spend it, and thus the multiplier effect will fail, is probably unfounded. U.S. households maintain a high propensity to consume. The real unknown in the current U.S. economy is due to its recent and rapid globalization. When you look at economic trends, nothing has more radically changed than the jump in the U.S. trade deficit, beginning around 1997. Our high propensity to import goods with our disposable income (income after taxes) has reduced the U.S. multiplier effect of any expansionary fiscal policy. U.S. consumers spend, but they purchase imported goods. Thus, in the short run there is an expansionary effect in the global sense, but not for the U.S. economy. For the expansionary effect to work in the U.S., it would be necessary for the countries from whom we import to also purchase our goods; i.e., there would be a drop in the trade deficit. A high trade deficit for the U.S. implies that the countries we import from have, in essence, excess dollars. So what do they do with these dollars if they don’t want our goods and services? The theory says that they should return the dollars in the form of investment in the U.S. This could lead to capital formation and increased jobs in the U.S. and the desired multiplier effect of fiscal policy. Unfortunately, these countries often stockpile dollars for some unknown future use or buy U.S. Treasury bills. In either case, it does not result in the traditional short-run multiplier effect.
Will the fact that this is an election year have any impact on the government’s actions regarding the economy?
In a Presidential election year, policy-makers accept compromises that they ordinarily wouldn’t make. The goal is to not alienate undecided voters. It was interesting to note that all but one of the major presidential candidates praised the proposed economic stimulus compromise. Even the Federal Reserve Bank, which is a privately owned enterprise and supposedly independent of direct government control, will be careful to undertake policies that it believes will not later become a political liability.
The stock market often is referred to as a “bull market” or a “bear market.” What do those terms mean?
These terms go back in history and there is only speculation as to their origins. Today a “bull market” is one in which there are more optimistic investors than pessimistic investors in the stock market. A “bear market” is one in which this is reversed. The prevailing view tends to follow the business cycle, and because there is a psychological component to the business cycle, can be a self-fulfilling prophecy.
What can the average person do to ride out a recession?
The first thing to remember is, if at all possible, don’t panic and sell your assets (stocks, bonds, etc.) at a loss. The expansion will return and prices will increase in the future. The second, and related part of this, is that if you have some unneeded liquidity, consider purchasing even more risky assets when their prices have fallen to some level below their long-run trend. The secret to having above-average success in the stock market is to accept moderate profits by purchasing when most investors are selling and selling when most investors are purchasing. If you are laid off and have some form of financing, it might be a time to consider obtaining additional education or advanced training. These represent investments in human capital stock, and if chosen wisely, will yield significant returns in the long run in a world where the U.S. labor force is competing with a low-wage, but largely unskilled international labor force.