It seems to me…
“The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.” ~ Milton Friedman.
I am not an economist but it is obvious that a variety of factors led to the 2009 financial collapse; one of these was excessive leveraging[i]. Leverage basically is the increase in debt relative to assets or income. Substantial increases in leverage eventually lead to economic instability and, if not corrected, to financial and economic collapse.
Collapse of the housing market resulted in increased borrowing restriction not only making it more difficult to borrow but also forcing debtors to “pay down” existing debts. Creditors encouraged debt increases in an expanding economy as it came with little risk: home values increase, prices of stock bought on margin went up, business sales expanded. Homebuyers that purchased their home with no money down and an interest-only mortgage were highly leveraged as was a business having a high percentage of its cash flow going to debt payment. Both had increased difficulty during the financial downturn and when a sufficient number of debtors attempted to de-leverage by liquidating assets at the same time, it lead to a self-reinforcing downward spiral of debt deflation – decreased purchasing and corresponding reductions in production and employment.
Following the economic collapse, those low expenditures by consumers, businesses, governments, etc. were the primary cause of unemployment and low economic output. Home construction and consumer product sales decreased substantially. State and local government revenue decreases resulted in correspondingly reduced expenditures. Business investment likewise decreased due to reduced sales. Insufficient spending results in increased unemployment since businesses will not produce what cannot be sold and will not hire workers not needed for production[ii]. The U.S. economy currently still has a residual problem of inadequate demand.
U.S. growth rates following each of recent economic declines have progressively slowed, recoveries have been jobless, and median wages have declined[iii] for more than a decade. The information revolution and globalization have negatively impacted high-wage countries such as the United States. These new forces are accelerating, and without a strategy to revive growth, all of our problems get worse, especially long-term debt. While the focus has been on taxes and deficit reduction, it should be on reforming and investing.
The best method of reviving growth is a combination of structural reforms, to increase economic competitiveness, and investments in human and physical capital, to ensure next generation growth. Government austerity while the economy remains caught in a liquidity trap is counterproductive as any fiscal savings will be at the expense of reduced output and higher unemployment. Fiscal savings are likely to be small and maybe even nonexistent: lower output and employment reduces revenues, and may inflict long-run economic damage that actually worsens the long-run fiscal position.
Rather than having negative impacts on growth, rising government debt while in a liquidity trap can be beneficial if used appropriately. Spending cuts when an economy is in a liquidity trap, regardless of whether those reductions are in the public or private sector, increase unemployment whereas spending cuts in an economy not at that zero bound do not.
Inadequate liquidity, regardless of the cause, can result in recession but frequently can be resolved by an increase in the money supply. This is only productive up to some point – exclusively expansionary monetary policies are counterproductive.
Federal monetary expansion while in a liquidity trap never can cause inflation as long as liquidity remains a problem since even if interest rates are set at 0 percent, they still are unlikely to restore full employment.
That’s what I think, what about you?
[i] The collapse and its primary cause was predicted by Hyman Minsky based on his “financial instability hypothesis”. He was said to have predicted nine of the past three financial crisis.
[ii] Krugman, Paul. End This Depression Now!, W.W. Norton & Company, Inc., New York, 2012, pp24-25.
[iii] Zakaria, Fareed. What’s Missing From The Cliff Debate: Growth, http://fareedzakaria.com/2013/01/03/whats-missing-from-the-cliff-debate-growth/, 3 January 2013.