It is argued by some people that a recession can benefit the economy, at least in the long run. The reasoning is that falling revenues force firms to become more efficient, e.g. cutting unnecessary costs e.t.c. In a recession, inefficient firms will go out of business and this shake up is necessary to weed out the inefficient and provide incentives for firms to be as profitable as possible.

This belief was articulated by the Chairman of Ryanair, Michael O'Leary's recently, arguing that a recession would be a good thing. see Guardian article

However, is this a good argument?

Problems of Recession - Why A Recession is Bad

1. A recession will make it difficult for new firms who have just entered the market. Most new firms have high set up costs, therefore, a downturn in the economy could make them close down. However, this does not mean that they are inefficient. It just means they are new and struggling to get established..
2. Increased Monopoly Power. If a recession causes the smaller and newer firms to go out of business then the larger dominant firms will gain more monopoly power. In the long run this will lead to less choice and higher prices. This is a definite disadvantage of a recession. When the Chairman of Ryanair argued recessions would be a good thing, maybe he meant - a good thing for Ryanair, as it may involve new firms going out of business leaving him more market power.
3. Hysteresis. This is the argument that the past is a predictor for the future. Basically, if you have high unemployment, then it is more likely to have high unemployment in the future. If people are made unemployed in a recession, it may take a long time for them to find work again. When they are unemployed they lose skills, become demotivated and become less attractive to employers. Note after the recession of 1981, Unemployment remained stubbornly high in the UK, even into the boom years of the late 1980s
4. Fall in Productive Capacity. A recession can damage the productive capacity of an economy. Firms can go out of business and therefore shut down their resources. Furthermore in a recession, there will be a significant fall in investment, this can harm the long term development of an economy.
5. You don't need a recession to weed out inefficient firms. If markets are reasonably competitive, inefficient firms will be forced out of the market anyway.

Conclusion:

A recession is unnecessary to increase economic efficiency. The long term future of an economy can be best helped through stable growth, which avoids the extremes of boom and bust economic cycles.

Definition of Recession

Labels: recession

There is much talk about the US economy entering into a recession. I notice on my statistics that quite a few people are searching. "What does it mean to enter a recession?"

A recession means a period of negative economic growth. This means there is a fall in National Output.

The official definition of a recession is when there is negative economic growth for two consecutive quarters. (i.e. for 6 months)

However, in practise people may talk about recession, even when the economy is growing very slowly. In economics we sometimes refer to this as a growth recession. This is because when economic growth is very low it means that we usually see many of the common features of recession.

In a recession the following usually occurs.

1. Lower Incomes
2. Rising Unemployment
3. Lower inflation
4. Higher Government Borrowing
5. Fall in sales of houses.
6. Fall in Business and consumer confidence
7. More spare capacity in the economy.

Note, the US economy is still someway off recession. Economic Growth is less than 2%, but, there is no immediate danger of leading to negative growth.

The problem in the US is that:

1. The Housing Market is in decline. In many cities house prices are falling.
2. The Stock market is falling, Partly due to the sub prime mortgage lending problems.
3. There are fundamental imbalances in the US economy

• low savings ratio,
• high debt levels,
• trade deficit and
• government fiscal deficit.
• Weakness of the dollar (related to trade deficit)

People are concerned that the combination of falling house prices, falling share prices and rising interest rates are likely to cause a recession.

If people fear a recession is about to occur, this fear can often make it happen. If you feel there may be a recession in the future then you will cut back on spending and this can cause a further fall in AD.

Related

• Is US economy heading into recession?
• Economic Recessions - revision notes
• UK Recession of 1981
  

Labels: recession

It is very well for economists to talk about the benefits of recessions - "creative destruction" but, recessions do create real personal hardships for individuals affected by unemployment, bankruptcy and falling incomes.

Problems of Recessions

Recessions don't necessarily weed out just the inefficient. Recessions can cause the bankruptcy of many good companies who just can't cope with the temporary downturn. This particularly applies to new companies.

Uncertainty

Recessions create uncertainty which discourages investment. People dislike the uncertainty of fluctuations in the business cycle. Moderate steady growth helps encourage investment.

Hysteresis.

This suggests that high periods of unemployment tend to lead to higher unemployment rates in the future. Basically, if people are unemployed it becomes more difficult to get work in the future. This is because they become demotivated e.t.c.

High Interest Rates do not affect people equally.

Higher interest rates may be needed to discourage excess borrowing and inflationary pressures. However, people often forget that interest rates are an imperfect mechanism. They do not affect consumers equally. For example, new homeowners with a large mortgage will be heavily affected by a small rise in interest rates. The older generation who have paid off their mortgage may actually welcome rising interest rates. This is because it increases the income from their savings.

• Benefits of High interest rates - Why recessions are not so bad after all
• Causes of Recessions
• Why Do recessions last a long time?
  

Labels: interest rates, recession

The economist carried an interesting article recently "Does America Need a recession?" August 25th 2007. They suggested that recessions can have certain benefits for economies. Furthermore Central Banks should not always seek to prevent mild recessions.

The main role of central banks should be:

1. Create a low inflationary environment
2. Create financial stability
3. Prevent Mild downturns turning into full blown recessions.

Therefore, there are many arguments against cutting interest rates at the first sign of panic. If necessary Central Banks should allow a moderate recession. These are some of the benefits of not cutting interest rates aggressively.

Benefits of Recessions.

1. Moral Hazard.

The argument is that people have been borrowing recklessly. This explains alot of the problems with the US sub prime mortgage market. As a consequence of reckless borrowing banks are suffering defaults, writing off debts and this is a contributing factor in the recent downturn in the stock market. However, if the central bank aggressively cuts interest rates, this merely encourages people to keep borrowing recklessly. If interest rates are kept high, people will think twice before undertaking imprudent borrowing.

Basically, the concern is that if interest rates are cut at the first sign of trouble, people will think it is fine to borrow beyond their means, - because the Central Bank will always help out debtors by cutting interest rates.


2. Financial Boom and Bust.

we can see two examples of Central Banks cutting interest rates too aggressively.

1987 saw a stock market crash of 25% in one week. Many felt this heralded a recession (like the great depression, following the wall street crash of 1929). As a consequence Central banks cut interest rates so that real interest rates were very low. This had the effect of pumping money in to the economy. In the UK particularly, this led to an economic boom and inflation. The result of this Lawson boom (high inflationary growth) was the need to raise interest rates aggressively to 15% in 1992. This caused a severe recession in the UK. Arguably the Central Banks should not have panicked because of the stock market crash. It was a mistake to make monetary conditions so loose.

A similar event occured in 2001 after the dot com bubble burst, and in response to the events of 9/11. The years following 2001 led to an era of very cheap credit. This underpined much of the boom in borrowing and the later problems of the sub prime market. If interest rates had been kept higher in 2001, it would have caused a little more pain then. But, it would have avoided many of US's current financial ills.

3. Deal with Fundamental Imbalances.

A downturn in the economy is usually the consequence of fundamental imbalances in the economy. For example, the US is experiencing a large current account deficit; which in turn is contributing towards a devaluing dollar. This deficit is mainly as a consequence of cheap credit and high consumer spending. Much of this spending goes on imports, especially from China. A period of high real interest rates would help reduce this imbalance in spending and saving.
Higher levels of spending would help in the long term lead to more investment and sustainable economic growth.

4. Creative destruction.

The economist J. Schumpeter, argued that recessions had many benefits for the long term success of the economy. In particular, recessions were an opportunity to weed out the inefficient firms and encourage firms to be more efficient. Although this may be painful in the short term it does have long term benefits.

More on Recessions

• Problems facing economies recovering from recessions
• Are recessions caused by failure of Monetary policy
  

Labels: recession

IS RECESSION A TOPIC LIKELY TO APPEAR IN UNIT 6 Edexcel?

It could come up in some form.

Essays on recessions could include:

• Causes of Recessions
• How a US recession might effect the UK
• Problems facing an economy recovering from recession
• Are UK recessions caused by a failure of monetary policy?
• Is US economy heading towards recession?
  

Labels: recession

There are concerns the US economy may be heading towards recession. If the US economy did go into a recession how would it effect the UK economy?

There is an old saying that "If America sneezes, the rest of the world catches a cold"

Discuss the effects on the UK economy of a Recession in the US.

A recession in the US will lead to a fall in UK exports to the US. If UK exports to the US are luxury goods there will be a bigger % fall in UK exports. A fall in Exports could cause a fall in AD. Therefore, it could contribute to a recession in the UK.

Furthermore, a recession in the US is likely to adversely effect consumer confidence in countries, such as the UK.

However, Exports to the US are a small component of AD. Only 16% of our trade is with the US, our biggest trading partner is the EU. Also, it depend upon other components of AD; for example, if UK domestic spending was rising rapidly (e.g. due to rising house prices) then UK AD will probably keep rising.

The UK is likely to have an appreciation in the exchange rate against the dollar, this is because interest rates in US are likely to be lower. Therefore, there will be more hot money flows into the UK. A stronger £ will make UK exports less competitive and therefore reduce AD further.

The effect of a stronger £ and fall in exports to US is likely to worsen the current account deficit. Exports increase relative to imports.

It depends on the strength of the UK economy. For example, at the moment the UK Central bank is concerned over inflationary pressures. A slowdown in exports could help reduce inflationary pressures without the necessity of rising interest rates.

Overall, the effect is likely to be fairly small. However, it depends why the US economy went into recession. If it was due to global phenomena it could effect UK as well.

related:

• Causes of recessions
• Is US economy heading towards recession?
  

Labels: recession

Essay: Discuss the effects on the UK economy of a Recession in the US.

A recession in the US will lead to a fall in UK exports to the US. If UK exports to the US are luxury goods there will be a bigger % fall in UK exports. A fall in Exports could cause a fall in AD. Therefore, it could contribute to a recession in the UK.

Furthermore, a recession in the US is likely to adversely effect consumer confidence in countries, such as the UK.

However, Exports to the US are a small component of AD. Only 16% of our trade is with the US, our biggest trading partner is the EU. Also, it depend upon other components of AD; for example, if UK domestic spending was rising rapidly (e.g. due to rising house prices) then UK AD will probably keep rising.

The UK is likely to have an appreciation in the exchange rate against the dollar, this is because interest rates in US are likely to be lower. Therefore, there will be more hot money flows into the UK. A stronger £ will make UK exports less competitive and therefore reduce AD further.

The effect of a stronger £ and fall in exports to US is likely to worsen the current account deficit in the UK.

It depends on the strength of the UK economy. For example, at the moment the UK Central bank is concerned over inflationary pressures. A slowdown in exports could help reduce inflationary pressures without the necessity of rising interest rates.

Overall, the effect is likely to be fairly small. However, it depends why the US economy went into recession. If it was due to global phenomena it could effect UK as well.

Related Essays

• Is the US economy heading into recession?
• Causes of Recessions
• Difficulties of Overcoming Recessions
  

Labels: recession

This is an interesting question asked by a reader, (thanks Bhavin.)

With regard to the recession of 1981 I think that the cause of the recession cannot be entirely attributed to Monetary policy.

Reasons for Recession in 1981

1. Structural problems in economy late 1970s.

In 1979 inflation was a significant problem in the UK economy. The inflation was primarily cost push inflation. This was a combination of wage push inflation, caused by powerful trades unions and rising oil prices. To reduce this inflation was arguably necessary for the long term benefit of the economy; to reduce inflation of 20% inevitably leads to some slow down in economic growth.

2. Strength of Sterling.

Normally the increased production of oil would be beneficial for an economy. However in the case of the UK it came at an unfortunate time. The discovery of oil combined with high interest rates caused a significant appreciation in the £. This caused real problems for exporters. It was in the manufacturing export sector where the recession was felt most keenly.

3. Monetary Policy

However, despite the above 2 being contributing factors, monetary policy played an important role in the recession of 1981. The government had a Monetarist zeal to try and control the money supply. Arguably this caused real interest rates to be higher than necessary. Therefore monetary policy caused the recession to be deeper and more lasting than necessary. This is a good example of the limitation of using monetary targets, rather than targeting inflation directly.



Causes of Recession 1991.

In my view the recession of 1991 can be attributed almost entirely to a failure of government macro economy policy. By 1987 the economy was in a good position. Supply side policies were beginning to increase competitiveness and structural inflation had been brought under control. The essential problem was that the government allowed itself to get carried away by the perceived success of its supply side policies. Therefore it allowed the economy to grow much faster than the long term trend rate of economic growth. Therefore inflation was almost inevitable. In response to inflation of 10% the government then overreacted by increasing interest rates to 15%. The failure of macro economic policy was highlighted by using the ERM as a tool for reducing inflation, rather than direct inflation targeting. Again the recession was deeper than necessary because they tried to maintain a value of the exchange rate that was higher than necessary.

In short the government made 2 elementary mistakes.

1. Allowed the economy to grow too fast - Boom and Bust

2. By targeting a high value of the exchange rate, they caused interest rates to be much higher than necessary to reduce the inflationary pressures they had created.


related posts

• Causes of Recession
• UK economy under Mrs Thatcher

Labels: recession, UK economy

How accurate are economic forecasts?


The “joke” goes put 12 economists in a room and you’ll get 13 different answers. I think it was President Truman who, exasperated at the economic profession, yearned for a “one armed economist” What Truman meant is he wanted an economist who wouldn’t invariable go onto the other point of view. It is the same with economic forecasts ask economists predictions for future house price inflation in the UK and you could get answers ranging from -7% to +10%


Economic forecasting is important. For example it is the basis of the UK’s pre emptive monetary policy. Because there is a time lag in interest rates having a deflationary effect, it is important to be able to predict future inflation. If inflation is forecast to rise then the MPC knows it needs to increase interest rates now to avoid inflation in the future. However if forecasts turned out to be wrong then they could easily increase interest rates too much, causing a slowdown in the economy.

In recent years it has been relatively easy to forecast inflation because it is has been low and has fluctuated by little. However this is not always the case and economists have a bad track record of being able to predict unexpected economic shocks. To give a few examples

* 1929 wall St Crash and great Depression.
* 1990s deflation and low growth in Japan.
* 1997 -01 dot com boom and Bust.

On the other hand there have been economists predicting a major recession in America and with defaults in the sub prime mortgage sector it appears they may soon be vindicated. I have a good friend in America who has been predicting the imminent collapse of the US economy for the past 7 years. I guess at some stage there will be a recession and he will feel vindicated. However this kind of economic forecasting reminds you of the boy who cried wolf. If you predict a recession every year, by the time it comes most people no longer take you seriously.

See also:

• Limitations of UK Monetary Policy
  
• Forecasting Recessions
• Forecasts for UK Economy
  

Labels: economic forecasts, recession

Is the US economy set for further growth or is a recession an inevitability for an economy that has been living beyond its means for a long time?

With Alan Greenspan suggesting the US economy has a 33% chance of entering into recession it is worth considering whether this is a realistic prospect or just a controversial parting shot from the 81 year old former Chair of the Federal Reserve. Alan Greenspan is held in high regard as an economist, some even credit him with “saving the US economy”. However his track record on economic predictions is mixed. He did predict a dotcom bubble bursting, (although it was 4 years before it occurred)

Reasons why the American Economy may enter a Recession.

1. Falling House Prices. After several years of a booming housing market. House prices are now starting to fall in most US states. Falling house prices will have a significant impact on consumer spending. As house prices fall, people can no longer remortgage to have extra capital to spend. Also falling house prices have a significant impact on consumer confidence. As housing is the biggest form of wealth it will adversely impact on the financial situation of most households. [1] America's past growth has been maintained by strong consumer spending, if this falters economic growth is likely to do the same.
   

2. House Prices could have further to fall. Looking at historic house price to earnings ratios the average US house price has been overvalued for several years. For the house price to earnings ratios to return to normal, house prices may have to fall by more than 18%. [2] Note the Japanese housing market provides a recent precedent for those who don’t believe house prices can fall for a long time.

3. Mortgage Lenders going Bust. Due to a record levels of default on sub prime mortgages, the number of mortgage lenders going out of business is at an all time high. [3] This has also changed other financial markets attitude to risk. Banks and stock markets will be much less willing to lend on dubious terms. The net effect is that investment and consumer spending will grow much slower, or even start to fall.

4. Current Account Deficit. The US current account deficit is currently 6.5% of GDP. [4] For a long time some economists have said there is nothing to worry about. The deficit has been financed by Chinese investors willing to buy US assets, even with a relatively low interest rate. However increasingly Chinese and Asian investors are seeking to diversify out of the US dollar. The dollar is losing its “safe haven” status. Partly because of events in Iraq and Afghanistan but also because of a realisation that the US economy is not as dominant as it used to be in the past. If the Chinese start buying less US securities it will cause a further devaluation in the dollar and also require higher interest rates to attract people to buy sufficient US securities. The higher interest rates will exacerbate any fall in US consumer demand.

5. Budget Deficit. The US has a twin deficit. As well as a balance of payments deficit. They also have a budget deficit. The effect of this is that it puts upward pressure on interest rates. Higher interest rates are required to attract investors to buy bonds and securites. Having such a large deficit also leaves the government less room for manoeuvre in terms of expansionary fiscal policy. If the US economy does start to slow down there is little scope for further tax cuts and increases in government spending.

6. High levels of debt. High levels of debt make the US economy susceptible to increases in interest rates. Higher interest rates may be necessary because of the twin deficits and falling dollar. Even a small rise in interest rates could have a significant adverse effect on heavily indebted consumers.
   
   
7. Falling Stock Market. By itself a falling stock market doesn't cause a recession, but it is indicative of the change in confidence and mood of the US economic situation that US share prices have fallen sharply since last week.
   

Reasons why the US economy may not enter recession.

1. High Economic Growth. Economic growth is still positive and inflation is under control. Current economic statistics are generally good, despite growth being revised downward. The Fed still expects growth of 2.75% - 3% next year

2. The Global economy is no longer dependent on US consumers. Economic growth in Asia and particularly China means that there is a growing Chinese middle class who will be increasingly willing to buy US exports in the future. It is possible the trade deficit could change over time. Especially as devaluation makes the US dollar more attractive.

[1] US house price sales fall 17%

[2] US house prices 18% overvalued

[3] US Mortgage lenders going bust

[4] US current account deficit

Other References

• Greenspan predicts US recession
  
• US economic data at Economist
• America’s Economy at Economist
  

Labels: Economic News, recession, US economy