The Great Recession – Why Government Intervention? The Promise and the Pitfalls

The American economy is in the middle of a ferocious retrenchment.  The statistics are not in dispute. The economy shed more than 651,000 jobs in February 2009, on top of over 500,000 jobs lost in January, bringing the total number of Americans looking unsuccessfully for work to a staggering 12.5 million. The national unemployment rate is a record 8.1%, a thirty year high. Drilling down below the national averages, the unemployment numbers are much worse for some groups. The unemployment rate last month was 13.4% for African Americans and a whopping 21.6% for teenage workers. A distressing 15 % of the unemployed have a college degree.  This is a huge waste of precious national resources, and a personal tragedy for those unemployed, and their families.

According to the most recent estimates from the Bureau of Economic Analysis, in the 4th quarter of 2008, the total economic pie as measured by the Gross Domestic Product contracted a stunning 6.3% on an annualized basis. The declines were deep and cut across all sectors of the economy.  Unsurprisingly, the only sector where demand increased was government spending and net exports since imports were down. Warren Buffet, the world’s most famous investor and a shrewd student of the economy, appropriately described the situation as “an economic Pearl Harbor.”

It is not surprising that the average citizen is confused and scared.  There are many unanswered questions.  What happened? How did we get here? How could some of the world’s most profitable businesses make such bad decisions? Why were so many analysts wrong? How could politicians, government officials, and regulators create this mess?  Did institutions of democracy and capitalism fail the people of America?

There is plenty of blame to go around.  Clearly even as some of those responsible for the economic fiasco have paid a price for poor judgment, unfortunately many others have not. This guarantees that the errors that led to the crisis will be repeated. According to most unbiased analysts, the current economic malaise originated in the growth and eventual collapse of a massive housing bubble and subsequent meltdown of several large firms in the vastly bloated and overleveraged financial sector leading to a freezing of the credit markets for important segments of the private economy.

The cumulative impact of greed, excesses, and hubris in Wall Street and in the halls of power was a catastrophic meltdown in the financial heart of the nation, and a collapse in the real economy that has cascaded to the rest of the world. In a blink of the eye, a staggering $14 trillion dollars in wealth has disappeared by some estimates, mostly in equity markets and business bankruptcies.  Despite a massive $700 billion bailout of the rogue financial companies, and an equally big stimulus package, the economy has yet to stabilize from its downward spiral.

Thanks to globalization, the crisis in the US economy has rapidly spread throughout the global economy, infecting one nation after another. Economic historians have to go all the way back to the stock market collapse of 1929 and the ensuing Great Depression of 1930s to find a crisis of similar depth and proportions; the Great Depression was also caused by the collapse of an overly bloated economy and stock market from reckless speculation that eventually spread to shutter down thousands of banks sending the economy into the dark tunnel of a decade long recession.

The trillion dollar question is, should the Federal government and the Central Bank wait for the economy to self-correct, or urgently intervene to prop up the economy? Consider some numbers.  If the economic decline continues at this pace, unemployment rate could be at double digits by summer of 2009.  For a $14.3 trillion economy, a one percent negative growth in the GDP results in the potential income loss of roughly $143 billion on an annualized basis. If the fiscal stimulus can be a catalyst for even a few points of positive GDP growth, it will pay for itself in greater incomes and output.

If nothing is done, no one knows how long it will take the economy to recover on its own. Looking at other major economies in Europe, and China who are caught in the crisis, none seem to be waiting for the economy to self-correct.  China has already announced a massive stimulus of over half a trillion dollars in infrastructure development. After Japan’s real estate bubble burst in the early 1990’s, analysts point to the lost decade in Japan once due to the slow and indecisive  response by the policymakers.  Fortunately, we can learn from Japan’s experience and not repeat errors made by their policymakers.  It would be tragic and wasteful for American workers and businesses to suffer through years of a painful recession which would erode the nation’s competitive position in the global economy.  Most economists agree on what ails the economy, and historically tested remedies are available.  A sufficiently large stimulus in the form of a combination of direct government expenditure and tax cuts should jolt the economy back to path to full recovery.  Like a bitter medicine given to a sick patient, the stimulus would have some unpleasant side effects and would take time to heal the economy, but it eventually it would.  It is a small down payment for nursing the economy back to good health and robust long term growth.

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