Recession of 2009

(The title of this article reflects the fact that the full intensity of the recession did not develop until 2009 and the fact that recovery was incomplete at the end of that year

Downturns in economic growth rates were apparent early in 2008, and the subsequent intensification of the financial crash of 2008 led to a general expectation of worse to come. The resulting loss of confidence by investors and consumers contributed further to the severity of the reduction in world economic growth, and it was apparent by the end of 2008 that the economies of the United States and several European countries had for some time been in recession. An impending collapse of the international financial system was averted by policy actions introduced in the winter of 2008, but credit availability had been only partly restored by the spring of 2009.

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The downturn

Throughout the period from mid-2007 to mid-2008, the growth of the world economy was hampered by increases in oil and food prices, and by a crisis in the financial markets. Oil prices rose from $75 to $146 a barrel and food prices rose sharply, forcing householders to cut their spending on other products. On the financial markets, the subprime mortgage crisis developed into the crash of 2008, as a result of which the availability of credit to households and businesses was curtailed, leading to further reductions in household spending and business investment. In the nine months to the middle of 2008, the advanced economies had grown at an annual rate of only one per cent (compared with two and a half per cent in the previous nine months) and the growth rate of the developing economies had eased from eight per cent to seven and a half per cent. According to the OECD the US economy was by then already facing substantial difficulties. Households had borrowed at an unprecedented rate during the previous 15 years, and their saving rates had fallen nearly to zero as they increasingly relied on housing wealth to finance consumption. With the housing market suffering the severest correction for 50 years, household wealth was declining, and with credit conditions getting tighter, households had been forced to reduce their reliance on borrowing, and job losses and mortgage foreclosures were rising.

The prospects of a recession in the United States and of substantial reductions in economic growth elsewhere were becoming apparent when the world economy was hit by another shock. The failure of the Lehman Brothers investment bank in September raised doubts about the creditworthiness of major global financial institutions, and the ensuing banking panic threatened a collapse of world’s financial system. Attempts by banks to restore their capital adequacy, resulted in capital hoarding, and the resulting liquidity shortage (or credit crunch) undermined consumer and business confidence, and triggered a further contraction in demand. Massive financial support to their banks by the governments of the industrialised countries averted a threatened collapse of the international financial system, but failed to restore the supply of credit to businesses and householders. Falls in demand, together with credit shortages led to a massive reduction in world trade.

Many industrialised and developing countries suffered reductions of economic activity. Economies with relatively large financial sectors - such as those of Britain and Iceland - suffered directly from the banking crisis. Economies with relatively large export sectors - such as those of Japan and Germany and many developing countries - suffered indirectly from the reduction in world trade. There were widespread increases in unemployment. Inflation rates fell, and the threat of damaging deflation was averted mainly by the monetary policy action by central banks' in which discount rates were slashed, followed - in a departure from accepted practice, after no further reductions appeared feasible - by programmes of quantitative easing. In another departure from accepted practice, the governments of the G20 group of major economies agreed to use fiscal policy in order to stimulate demand by tax cuts and increases of public expenditure.

Budget deficits grew during the downturn, mainly as a result of the operation of automatic stabilisers and, to a lesser extent, as a result of discretionary fiscal policy, and the levels of debt owed by the governments of the industrial governments were forecast to rise to an average of 120 percent of gdp by 2014.

The economic recovery

Although in purely technical terms the recession ended in several countries in the summer of 2009, levels of activity remained substantially below normal levels and there was considerable uncertainty about future prospects. In view of a continuing credit shortage, there were few expectations of an early return to pre-recession growth rates, and there were some fears of a long period of near-stagnation such as that suffered by Japan during the period 1990 to 2005. The American economist Paul Krugman argued that what happened in Japan may have been due to a reluctance to spend on the part of householders impoverished by collapses of housing and stock market bubbles, and the Japanese economist, Richard Koo applied the term "balance sheet recession" to a situation in which companies as well as householders reduce spending in order to repay debts and rebuild reserves. Reports of increases in household saving ratios in the United States and Britain tended to add to those fears, but it has been argued that Japan's experience is unlikely to be repeated by the United States or the other indebted economies because their bubbles were proportionately smaller, their banks tend to be more profitable, and prompter action has been taken to recapitalise their banks.

The policy debate

Overview

A conflict developed between those who fear that the resulting fiscal expansion may be insufficient to counter growing output gaps - and those who consider fiscal policy to be unnecessary or ineffective - or who fear the possibility of sovereign default. Among the first group were the Nobel prize-winners Paul Krugman , and Joseph Stiglitz . Among the others were the Chicago School's Eugene Fama, and a group of eminent British economists who argued that "occasional slowdowns are natural and necessary features of a market economy" and that "insofar as they are to be managed at all, the best tools are monetary and not fiscal ones".

Fiscal policy

The consensus view

By October 2008, policy-makers in most industrialised countries had accepted that in order to avoid the development of persistent and unmanageable deflation such as occurred in the pre-war great depression, early corrective action would have to be taken, going beyond the necessary restoration of activity in the financial system. Most countries had long abandoned the use of reductions of taxation and increases in public expenditure to ward off economic downturns in favour of the use of interest rate reductions , but there were doubts whether monetary policy would be sufficiently powerful, or sufficiently quick-acting in view if the severity and imminence of the current deflationary threat. In the United States, in particular, the federal interest rate had already been reduced to 1 per cent - leaving little scope for further reductions, and banks there and elsewhere had become reluctant to pass on central bank reductions of interest rates.

The consensus view among economists, as expressed by the Chief Economist of the OECD is that :

Against the backdrop of a deep economic downturn, additional macroeconomic stimulus is needed. In normal times, monetary rather than fiscal policy would be the instrument of choice for macroeconomic stabilisation. But these are not normal times. Current conditions of extreme financial stress have weakened the monetary transmission mechanism. Moreover, in some countries the scope for further reductions in policy rates is limited. In this unusual situation, fiscal policy stimulus over and above the support provided through automatic stabilisers has an important role to play. Fiscal stimulus packages, however, need to be evaluated on a case-by-case basis in those countries where room for budgetary manoeuvre exists. It is vital that any discretionary action be timely and temporary and designed to ensure maximum effectiveness.

In its 2008 World Economic Outlook, the International Monetary Fund has also noted that fiscal policy can quickly boost spending power, whereas monetary policy acts with long and uncertain lags , and a 2009 IMF Staff Position Note demonstrates that an internationally coordinated programme of fiscal expansion, combined with accommodative monetary policies, can have significant multiplier effects on the world economy .

The case for fiscal expansion eventually gained near-universal political acceptance, and by early 2009, nearly all the G20 countries had introduced fiscal stimulus programmes .

The operation of automatic stabilisers - augmented by discretionary fiscal expansion - in developed countries resulted in increases in national debt, and there was general recognition of the eventual need for offsetting fiscal contraction (ie reductions of public spending and/or tax increases). Views differed, however, about the timing of such action. In October 2009 the IMF cautioned against haste:

"Notwithstanding already large deficits and rising public debt in many countries, fiscal stimulus needs to be sustained until the recovery is on a firmer footing and may even need to be amplified or extended beyond current plans if downside risks to growth materialize"[2].

However, the IMF also advised that a fiscal stimulus could do more harm than good if it made debt unsustainable, and suggested that further stimuli should be confined to countries with fiscal space to expand, such as the United Kingdom, China, France, Germany, and the United States , as compared, for example, with Japan and Italy. A spread in fears of government insolvency could hamper recovery because a perceived risk that governments might find it more convenient to repudiate their debt could lead to an increase in the cost of borrowing. They reported some signs of an increase in such fears in early 2009 and although they considered the perceived risk to be small, they considered it important that governments should present plans that would reassure markets that fiscal solvency is not at risk.

Objections

Professor Eugene Fama of the University of Chicago argues that consumers do not respond to tax cuts because of awareness that they will eventually be paid for by tax increases (the argument known to economists as Ricardian Equivalence). He also argues that all forms of fiscal stimulus are ineffective because they merely move resources from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment (the argument known as crowding-out). Others have argued that the danger of incurring unsustainable debt , makes fiscal stimulus a risky option, especially for countries with high levels of national debt. There have been warnings of resulting disaster, even for countries with modest ratios of national debt to GDP. Another objection arises from the fear that expansionary fiscal and monetary policies would not be reversed in time to avoid inflation (that objection was expressed by the economist Allan Meltzer in the same issue of the New York Times in which the economist Paul Krugman was advocating a further stimulus in order to avert the danger of deflation ).