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Popular Economics Weekly

Why is this recession so deep and long lasting? Because its underlying cause was magnified by a fickle private business sector that ran for the exits at the first sign of trouble. That is, private businesses seem to have little tolerance for uncertainty these days and so are quick to cut jobs and investment spending when it threatens their bottom line profits.

And with a weak regulatory environment and meager social safety net, it has become easier for businesses to lay off workers. The result is the sudden loss of consumer demand for their goods and services, which exacerbates the normal up and down business cycle and results in a recession at least once every decade.

That is why government support is necessary to shorten the recovery periods. Without that aid, consumers would have very little spending power and businesses no one to sell their products and services to, until the private sector decides it is safe to expand again. Government and the Federal Reserve have basically done a good job in shortening the length of recessions. The average recession length since WWII is 10 months, vs. 18 months before WWII.

So when this recession began brewing in 2007—not only did businesses begin to slash their workforce, but banks and investors began to hoard their assets. The result is more than 7 million jobs have been eliminated in less than 2 years, banks are holding $800 billion in excess reserves beyond capital requirements, and investors are hoarding more than $9.6 trillion in so-called MZM accounts—Money at Zero Maturity— such as money market and bank deposits.

Such was the panicked reaction of private sector business to collapsing credit markets that the Federal Reserve was not able to halt the downturn when they lowered interest rates, the usual result of such actions. In fact, banks stopped lending altogether, causing what is called a liquidity trap. This is when the money in the economy is no longer circulated by companies or consumers, but sits unused. The result has been a freeze in business activity, which is leading to a deflationary spiral, the most dangerous kind of recession. That is when not only prices drop, but incomes also.

This recession began December 2007, according to the National Bureau of Economic Research, causing 4 quarters of negative GDP growth, and probably ended sometime in July-August 2009. So it lasted at least 20 months, far above the average post-WWII duration.

One would think it is self-evident that when the private sector becomes risk-averse it is government’s job to step into the breach by substituting government spending for the lack of private investment. But such New Deal thinking only came into vogue during the Great Depression.

It was Roosevelt’s first Labor Secretary, Francis Perkins, also the first female cabinet member in history, who was the prime mover of much of the New Deal, including social security, unemployment insurance, and many of the depression-era public employment projects such as the WPA that employed millions, paying small, subsistence wages. She did this long before economists began to think of such aid, and even before Lord John Maynard Keynes formulated his economic theories in 1935 that justified such support during dire times.

The seriousness of the current Great Recession has warranted similar government aid. Only this time it is being done with both direct and indirect government stimulus spending. The Treasury is disbursing most of the $787 billion ARRA and $300 billion in TARP funds, while the Federal Reserve is purchasing upwards of $2 trillion in various asset-backed securities to support the record low interest rates.

The result to date is maybe 1 million jobs saved or created, a real estate market slowly gaining in strength, and an economy growing for the first time in a year. The Fed has said they won’t even begin to raise rates until the job market recovers. That means the unemployment rate has to decline back to the 6-7 percent range from today’s 10.2 percent rate.

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It could take years, given the hiring reluctance of private employers. The Federal Reserve in particular has learned the lessons of the Great Depression, which was prolonged because credit was tightened too soon. Fed Chairman Ben Bernanke is in fact a student of the Great Depression. The government is almost the only source of economic activity at present, but a real recovery will happen only when private business dares to venture back into the marketplace.

Harlan Green © 2009