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By Steve Levy

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About this blog: I grew up in Los Angeles and moved to the area in 1963 when I started graduate school at Stanford. Nancy and I were married in 1977 and we lived for nearly 30 years in the Duveneck school area. Our children went to Paly. We moved ...  (More)

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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.

Comments

Posted by Hal Plotkin, a resident of ,
on Apr 16, 2009 at 11:50 am

Hal Plotkin is a registered user.

I'm delighted to see this blog, Steve. I've learned so much from you over the years, it is a delight to see you writing here. Thank you.

Here is my question about the recession/depression.

The most troubling analysis I've read recently indicates that the real problem with the AIG bailout (not the phony diversion over bonuses), is that the federal government has stepped in and promised to pay the holders of AIG's credit default swaps 100 percent, in full, when loans go bad. Those instruments are held mostly by big banks and hedge funds, as you know. But to collect this money the banks and hedge funds have to push their borrowers into default. Thus, they have no real incentive to modify loans or work with borrowers. Instead, (as the WSJ reported yesterday) many are actually raising interest rates and such, in what looks like a clear effort to create the failures that will let them cash in their government backed credit default swaps at 100 percent, with no haircuts.

I've seen several columns that say this is why we can expect not a slow recovery but instead a continuing and perhaps even accelerating wave of bankruptcies and foreclosures in the year ahead. For example, see this link: Web Link -- cited on Joel Kotkin's New Geography blog.

What do you make of this argument/theory? Has our federal government inadvertently set up a dynamic that will protect the holders of credit default swaps at the expense of our larger economy? Or is this just a fringe effect that won't have much impact on our overall economy? I'd be very curious to know what you think...

Thanks again,

Hal




Posted by stephen levy, a resident of ,
on Apr 16, 2009 at 4:24 pm

stephen levy is a registered user.

Hi Hal,

Thanks for the kind words. I just wrote a long answer, hit submit and watched it disappear into the ether. I forgot to do it offline so have no copy.

I will try and recreate the answer to your good question but now it may be Saturday until I can get to it again.

Steve


Posted by stephen levy, a resident of ,
on Apr 17, 2009 at 2:07 pm

stephen levy is a registered user.

Hal,

I am not an expert in all of the technical aspects of CDS or the AIG bailout.

To me what is going on goes under the heading of "pick your poison".

My take is that the administrations (Bush and Obama) made a conscious decision to aid AIG knowing that the money would go partly to large banks and other investors. They certainly knew that the support for AIG would stop investors from having to negotiate with AIG regarding loss sharing—the inadvertent dynamic you mention.

But they believed that a bankruptcy for AIG or substantial losses to the CDS holders would pose more risk to the world's financial system. That is what President Obama has said consistently. This is part of the administration's broader theme that it is necessary to help Wall Street in order to help Main Street, meaning the broader economy. So they are helping the CDS holders not at the expense of the economy but in order to help the economy recover.

The administration is caught with difficult choices. They are trying to walk through the rain drops in the sense of stabilizing the financial system without taking over too many firms. This leads to some incentive structures that seem like they are rewarding "undeserving" institutions in order to help the economy.

They are making the same kind of decision in setting up the incentive system to encourage private investors to buy so-called toxic assets from banks. The investors get most of the rewards while taxpayers bear most of the risk. This will probably lead investors to bid "too high" for some bank assets but this may be the only way to get banks to sell the assets and clear space for more lending.

I think this approach along with the stimulus package and the housing initiatives have a good chance of working. But if we don't see progress by mid-summer my instinct is that the president will be true to his word and we will see Plan B.

The best antidote for families and the financial sector is an effective economic recovery and growth plan.


Posted by Peanut Gallery, a resident of ,
on Apr 18, 2009 at 10:34 am

Peanut Gallery is a registered user.

"amount of job loss" or "number of job losses," but not "amount of job losses." That and the confusion between the use of less and fewer ...


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