Monday, February 2, 2009

An Explanation of Recessions and Credit Crises

From a friend:
"A question from the econ challenged about the current crisis. So today's NYT
that people are saving too much and that this is driving a decline in
spending that's hurting the economy. Moreover, it's been a general meme of
the stimulus debate (See this week's Meet the
Press<>for a good example) that the
stimulus should be in a form that's spent and
not saved. But isn't one of the big long-term problems that Americans aren't
saving and so we're in debt to foreign countries? I can't figure out if the
issue is just the saving rate needs to rise more slowly, or if present
economic health is being traded for not solving a long-term problem."

The long-term short-term framework isn't a bad one to start with, but it's complicated by the fact that there's a credit crisis involved as well as a recession.

To start - a recession is when GDP falls - that's a measure of how much is produced inside this country, and changes in GDP are highly correlated with changes in things like employment, standard of living, etc. Generally, GDP up is good, GDP down is bad, with an added factor that GDP down by more than expected is especially bad because nobody's prepared for it.

A credit crisis is where banks don't have enough assets (like mortgages people will pay them back) to offset their liabilities (like deposits we give them to hold that they will have to pay us back if we ask for them). Therefore, banks can't lend money to anyone cuz they need as much cash (an asset) as they can to offset liabilities.

For recessions without credit crises, spending stimulates short-term GDP, whereas savings does not. Therefore, if you're looking to stem a normal recession, you want stimulus in a form that will be spent, not saved.

However, you are correct in that Americans individually aren't saving (which led to these crises in the first place) and America as a country is a debtor. On a long term basis, that's not sustainable, so in a sense, if you avoid savings in a stimulus package in America, you're mildly exacerbating a long-term problem to stem a severe short-term problem.

However, Americans don't save much period, and for a lot of people, "saving" entails paying down credit card debt. Because of high interest rates, in terms of a stimulus, that pays for itself in like 2 or 3 years, so for the long term economic and social prosperity of Americans, "saving" can be a great thing. That's an effect that's difficult to work into models, however, because it's long term and specific, so it sometimes gets ignored.

So just for recessions, you need to balance short term prosperity with long term prosperity. Politicians are overwhelmingly short-term oriented, typically, but rational treatment is probably somewhere in the middle.

Credit crises make this calculation more difficult. We haven't had a credit crisis in almost 20 years, although we've had one or two recessions since then.

In this credit crisis, there is a crushing rate of defaults on mortgages and other debt. Therefore, the assets banks had (money people owed them) are less valuable than they thought, and so they don't have enough money to service their liabilities/deposits (like savings accounts that people can ask them for money from). Thus, the bank fails. This means no bank is willing to lend because they need to hold onto as much cash as they can to service their liabilities. Without lending, the economy won't recover at all, because most business activity requires at least some lending (for a business to pay for raw materials with a credit card and pay it down at the end of the month, for example, there needs to be a bank willing to lend them that money. Same with building new factories, hiring more workers, etc). Less business activity reduces GDP, so without fixing the credit crisis, you can't fix the recession. Therefore, increased saving can be a great thing, because banks then have more money to service pressing liabilities.

So for the overall set of problems, you have to try and calculate what will be better for banks - an increased savings rate (meaning lower default rates on debt for those who save) or an increased GDP (which means less unemployment and greater overall prosperity, so lower default rates for everyone). There's an optimal mix of the two, but there's lots of controversy as to what that is. Secondarily, once the credit crisis is addressed, you also need to balance short-term GDP with long-term GDP, as with a normal recession. That's a major reason why there's so much disagreement among economists as to the best course of action. This of course dismisses the many political agendas of academics, wall streeters and politicians, which only complicate matters.

There's also an issue of efficient spending - you can hire a firm for a million dollars to build a bridge and another firm for a million dollars to blow it up, and you've technically added 2 million to GDP (more than that, once they turn around and spend the money they're given), but you haven't actually done anything with any social utility. So GDP is limited in its measurement capability, which adds a whole different twist to the works that significantly favors tax cuts over excessive infrastructure spending. We do need some infrastructure spending, though, because we've underspend severely in recent decades. So that's a whole separate calculation that needs to be made.

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