When recession hits, theories conflict - Explaining the "Great Recession"
Much debate surrounds the recent economic and financial crisis that has gripped the U.S. economy. But while contemporary economists have yet to reach a consensus, it is possible to get an understanding of the crisis by reaching back to past economic scholars. While economic thought has yet to deliver a universal theory for recessions, examining the various theories can help one connect the different puzzle pieces and get closer to the truth - as well as discover a way to recovery. This paper will examine how five major theorists would explain the crisis and what they would propose to solve it.
John Maynard Keynes, who was active during the Great Depression, would suggest that the preponderance of speculation and quest for profitability was responsible for the recession. Keynes was critical of speculators in his General Theory of Employment, Interest and Money, and suggested that financial systems were changing in order to accommodate people who invested for quick profit, as opposed to long term capital operations, which Keynes called "enterprise investment." Per lecture, Keynes saw that there was a growing separation between ownership and management. The owners no longer manage the company; instead their ranks are dominated by professional investors who are more likely to be skittish and will sell their shares at the first sign of trouble. But these speculators, who try and time the market, will increase instability in the system, according to Keynes. Somewhat presciently, Keynes points out that New York in the 1930s was teeming with speculators:
In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, "for income"; and he will not readily purchase an investment except in the hope of capital appreciation (Keynes, Chapter 12).
To apply Keynes' theory to the modern day situation, banks and other financial institutions got themselves in trouble by taking on too many risky assets. But these institutions bought up subprime loans because they were making their way down the MEK schedule. As they purchased riskier assets, corporations also took on more debt. This debt would become a problem when the first of the subprime loans went bust. Companies like AIG, Bear Stearns and Lehmann Brothers discovered that they were overleveraged and began to collapse. This event led to a financial panic because the professional speculators, who owned a majority of financial stock, quickly sold their shares. As a result, "The S&P 500, the broad U.S. stock index . . . lost 22% of its value in six trading sessions, from Oct. 2 to Oct. 9" according to a report by Business Week (Steverman 2008).
While an investment break down led to the crisis, Keynes would suggest that the government undertake expansionary fiscal policy in the form of government spending. Keynes argues that when interest rates fall to zero, as they have now, the central bank will be stuck in a liquidity trap - it can't lower rates, but can't raise them either because that would make the crisis worse. Thus, dealing with consumption is the more appropriate response. Government spending, according to Keynes, is the quickest way out of the crisis because it has a larger multiplier on aggregate demand than consumer spending (which will not be stimulated as much via tax cuts). The Obama Administration, with its $787 billion stimulus bill among other packages, is currently following a Keynesian approach.
Joseph Schumpeter, in The Explanation of the Business Cycle, would agree with Keynes' theory about an investment breakdown, but he would focus on the boom period instead. Schumpeter argues that boom periods create the conditions for busts, mainly through inflation and the excess creation of credit. In the beginning of a cycle, (which is generated through some change in the system, like an upgrade in production methods), Schumpeter says that the demand for investment raises prices for capital goods, including wages in the capital goods sector. Eventually, this will lead to increased consumption for capital goods and consumer price inflation. But as price rises, borrowing increases. This action forces bank rates of interest up and the natural rate of interest down. When the bank rate equals the natural rate, investment will decline. In addition to this endogenous decline, Schumpeter points out how banks can create credit over and above the level of savings. Thus, credit is not like normal money and not regulated by the central banking authority. Inflation can rise from the overexpansion of credit, but eventually bank credit inflation will end in self-deflation. To apply Schumpeter's theory, it would appear that during the housing construction boom of the early 2000s, the demand for housing (driven by subprime loans) ultimately lowered the natural rate of interest, causing a slowdown in investment. But even more damaging to the economy was the advent of securitization, an "innovation" which drove profits. However, as the banks issued countless derivatives backed by these unsafe loans, they sowed the seeds for "creative destruction" in the financial sector. Thus, when the bubble popped, housing assets began their self-deflation and the economy spiraled into a recession.
Schumpeter would suggest that an economy will find its way out of a recessionary period by discovering new forms of technology, which will lead to new innovations to drive profit. However, Schumpeter would likely caution that in the next boom period, authorities should monitor the creation of credit and the "irrational exuberance" of investors if it wants to minimize the next natural downturn.
Milton Friedman of the Monetarist school would argue that the management of the money supply during the boom period was responsible for the current downturn. Friedman argues that when a central bank attempts to target interest rates, it often makes a situation worse. Friedman points to the Federal Reserve's actions that took place in the early 1920s and late 1930s as an example of the Fed's ineptitude. During each period, the Fed sharply adjusted its monetary policy by raising interest rates, or in the case of 1936 and early 1937, doubling reserve requirements for banks. Friedman and Anna Schwartz point out that "these actions were themselves followed by sharp declines in the money stock, which were in turn followed by a period of severe economic contraction." For the champions of orthodox monetarism, "monetary changes were seen as the cause, rather than the consequence of major recessions" (Snowdon, Vane 170). Even more so, Friedman and Schwartz go further by pointing out during the Great Depression, the Fed's adjustment of discount rates caused numerous banks to fail and led to a decline in the state of confidence. The money supply's dramatic fall between October 1929 and June 1933 were the consequences of the Fed's blundering policies. "In this interpretation, the depression only became great as a consequence of the failure of the Federal Reserve," according to the monetarist school (Snowdon, Vane 171).
Robert Lucas and Ed Prescott, who pioneered the Real Business Cycle Theory, would argue that the current recession is a response to natural excess in the marketplace. In this theory, growth shocks from exogenous changes in technology set off a boom period, however overinvestment will cause the economy to bust. But for Lucas and Prescott, the bust is a natural reaction for efficient markets. They would argue that the current crisis likely stemmed from the overdevelopment of the housing sector during the early 2000s, and this rapid construction caused a fluctuation in the economic system. According to lecture, fluctuations are natural because they destroy some excess, and set an economy back to a reasonable path. But since downturns are the natural response of efficient markets, they should be allowed to happen, with no government interference. Thus in the modern case, Lucas and Prescott would argue that the government's current spending plans will only exacerbate the recession and prolong the economic pain before the United States recovers. They would argue the government should cease all recovery attempts immediately so as to prevent further damage. In a way, Real Business Cycle Theory is Darwinian - those that are not capable of adapting are destroyed in the process of natural economic extinction.
Hyman Minsky, the final economist to be examined, would suggest that the crisis occurred because financial institutions took on too much debt over the cycle and eventually collapsed under their own borrowing. To apply Minsky's "Financial Instability Hypothesis," one would say that in the beginning of the cycle, most financial corporations employed Hedge Financing because they could cover their investments with cash flow. Indeed, led by the innovation of securitizing mortgages, banks and other corporations were quite profitable in the early 2000s. But in their quest for greater profits, Minsky would argue that institutions slowly turned to speculative financing, as they over expanded and could only cover their interest payments with debt flows. By 2007-8, many of the banks for example were using Ponzi financing; borrowing more to pay off their debts. This can be seen in corporations like Lehmann Brothers who took leveraging to the next level:
Between 2004 and 2007, Lehman swelled its balance sheet by almost $300 billion through the purchase of securities often backed by residential and commercial real estate loans. But in the same period, the firm added a miniscule $6 billion in equity. As a result, assets jumped from an already high level of 24 times capital, to 31 times. So if the total value of the portfolio declined by 3% or so, shareholders' equity would be erased. (CNNMoney.com 2008).
Corporations that use Ponzi financing are highly unstable, and thus when the subprime bubble burst, they were overexposed and abruptly collapsed. In order to solve the crisis, Minsky would argue that institutional reform should be brought about by more regulation (to better monitor how debt is accumulated) and a clearing of debt from corporate balance sheets. When businesses are clear of debt, they can return to hedge financing - making investments that will pay off without having to borrow more money.
Corporations that use Ponzi financing are highly unstable, and thus when the subprime bubble burst, they were overexposed and abruptly collapsed. In order to solve the crisis, Minsky would argue that institutional reform should be brought about by more regulation (to better monitor how debt is accumulated) and a clearing of debt from corporate balance sheets. When businesses are clear of debt, they can return to hedge financing - making investments that will pay off without having to borrow more money.
2,081 words, 7 pages
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