The Great Recession Explained

By: Bill Mitchell

July 1, 2011 \In

terms of the economic crisis this is what actually happened: Private spending collapsed as a result of the effects on confidence of the global financial crisis. Firms felt the pinch as inventories rose and cut back production. The spending collapse was sharp as was the production response.

1.

2.

Unemployment rose as firms sacked their workers and the impact of the lost spending arising from the unemployment worsened the situation. Government revenue fell sharply because of the unemployment and they were forced to increase outlays via existing welfare provisions the so-called automatic stabilisers that are built into government fiscal policy. The consequence budget deficits rise (or surpluses fall) solely as a response to the decline in economic activity the problem is the unemployment not the rising deficits. Governments also chose to increase their discretionary net spending despite advise from conservative economists and Austrian school adherents who claimed the market would resolve the problem quickly. The dominance of neo-liberal thinking was weakened but still was evident in the misguided reliance on monetary policy. Central banks cut interest rates and engaged in quantitative easing. The premise was that these policies would reduce borrowing costs and stimulate credit demand. There were two things wrong with this approach: (a) it doesnt work. Consumers and firms were not borrowing because banks didnt have enough funds. They were not borrowing because they were pessimistic for the future and realised they were carrying record levels of debt which

3.

4.

5.

had to be reduced via saving; and (b) the central bankers thought it would work which makes you wonder why they would want to be pushing the private sector to accumulate more debt when the crisis was the manifestation of excessive private debt. What had to happen was a move from credit-based private spending (particularly consumption) to public spending. 6. Public debt levels rose because governments have been hectored into retaining institutional arrangements that were relevant under the gold standard but totally superfluous under the fiat monetary systems that emerged when President President Nixon abandoned what had been called the gold standard (or US-dollar standard). Under that monetary system which endured for 80 odd years (with breaks for war), currencies were convertible into gold, exchange rates were fixed and governments could only expand their spending by increasing taxes or borrowing from the private sector. After 1971, governments issued their own currencies which were not convertible into anything of value and were floated freely in foreign currency markets. Most nations have operated fiat monetary systems ever since and as a result national governments no longer have to fund their spending. The level of the liquidity in the system is not limited by gold stocks. Under the gold standard governments had to borrow to spend more than their tax revenue. But since 1971 that necessity has lapsed. Governments issue debt to match their deficits now as a result of the pressure placed on them by neo-liberals to restrict their spending. The conservatives know that rising public debt can be politically manipulated and demonised and this places a brake on government spending. But there is no operational necessity to issue debt in a fiat monetary system. Interestingly, the conservatives become schizoid when public debt is involved. The on-going public borrowing provides corporate welfare in the form of risk-free income flows to the rich. The fact that bond yields have remained low throughout the crisis (reflecting strong demand for public debt) tells you that the parasitic bond markets do not buy the neo-liberal political rhetoric. They know that national governments (outside of the Eurozone) have no solvency risk.

7. There are massive stockpiles of machines and productive capital idle and ready to be brought back into production but there is no spending to justify switching them on. One of the problems of a lengthy recession is that firms go broke and productive capacity is scrapped reducing the potential output level. The longer the recession the worse this problem becomes. It is true that creative destruction is a positive force that emerges during a recession. Low productivity capital is driven out and in the recovery best-practice capital is introduced so the overall vintage of capital becomes younger and more productive. This is one of the arguments that the conservatives make let the recession rip and clean out all the bad capital. But when the recession is deep and long, otherwise productive capital is lost and the future growth path is severely compromised as a result. When that impact is observed (as it is now) it becomes much harder to kickstart the economy and the losses are very large. 8. Most importantly, there are millions of workers who still have two arms and legs as before willing to work but unable to find jobs. The real situation seems to have become obscured in all the policy debates at present. Prior to the crisis, the overall aim of this neo-liberal agenda was clear reduce government protection of the weak and transfer power to employers by undermining the capacities of trade unions to bargain for advantage. While the public justifications were all about creating more jobs and reducing the poverty the reality was different. Since 1975 most nations have failed to create enough jobs to match the willing labour supply. The program of deregulation and the attack on workers rights set in place the conditions for the global financial crisis.