October 1, 2016

Making the Most of the Next Recession

Veronique de Rugy

Senior Research Fellow
Summary

Greater flexibility in prices, wages, and the ability to hire and fire or start and dissolve businesses means an economy better able to avoid (or at least minimize) the consequences of a recession.

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The U.S. economy is teetering on the edge of a cliff. The federal government's mounting debt combined with slow economic growth and exploding entitlement spending all but guarantee a recession is in our near future.

That isn't necessarily a bad thing. Recessions are part of the natural economic cycle. In the best-case scenario, they restore balance to an economy by "cleansing out the misuses of labor and capital," says John Tamny, senior fellow in economics at Reason Foundation. "Recessions, while painful, are the happy sign that growth is on the way."

Unfortunately, the upsides of recessions can be wiped out by bad government policies that prevent the economy from making needed adjustments. What's more, many policies aimed at "moderating" recessions can lead to excesses in the economy that make the next downturn even worse. Instead of redirecting resources to more efficient uses, these measures often cause a doubling down of investment into wasteful endeavors that produce little in the way of surplus for society.

Writing for The New York Times in December 2008, George Mason University economist Tyler Cowen explained how the 1998 bailout of Long-Term Capital Management, a hedge fund, harkened the Great Recession of 2007–09. It's true that move prevented large disruptions in capital markets that would have made the situation more painful for some in the late '90s. However, Cowen wrote, "with the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed—as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed."

Government produced a sense of immunity for many in the financial sector, thus contributing to the biggest financial crisis since the 1930s. And this is but one example of government interventions that are aimed at helping ease economic problems in the near term but get in the way of necessary reallocations of resources and set the economy up for even bigger problems in the future.

Thankfully, there are things that can be done to help us better weather the next economic downturn and achieve faster growth in its aftermath. For starters, we should be working to restore flexibility in the economy, reduce uncertainty, and bring down our public debt.

Greater flexibility in prices, wages, and the ability to hire and fire or start and dissolve businesses means an economy better able to avoid (or at least minimize) the consequences of a recession. Minimum wage laws and long-term unemployment benefits, while well-intentioned, actually make the labor market less flexible and slow down the recovery.

Similarly well-intentioned policies that try to stop prices from falling simply shift the correction to the "quantity" side from the "price" side, which often creates more dramatic consequences. Imagine what would have happened if the feds during the Great Recession had banned people from selling their homes for less than they paid for them. The answer is clear: Demand for houses would have plummeted; no one wants to buy something that costs more than it's worth. Taking a loss on real estate is no fun, of course, but not being able to get out of a bad investment is far worse. Sometimes, prices needto come down in order to give everyone a fresh start.

Besides allowing prices to adjust organically, the government must learn to stop injecting uncertainty into the economy. Bob Higgs, a senior fellow in political economy at the Independent Institute, has shown that "regime uncertainty"—which happens when there's a widespread inability to form confident expectations about how private property rights will be treated in the future—dampens investment. When people think government officials might decide to seize what they have, they generally choose to remain on the sidelines, hoarding their wealth, putting it only in low-risk, low-return, short-term investments, or consuming it now when they know they can. But during a recession, less investment translates into less recovery.

What can be done to end regime uncertainty? "As long as the rulers possess great discretionary power, the peasants will be subject to all the uncertainties created by the vagaries of the rulers' exertion of their power," Higgs says. "A long season of 'do-nothing' government would help a great deal."

Uncertainty is also created by regulation. Take Dodd-Frank, the most significant reform to U.S. financial regulations in over 70 years, which was enacted in the aftermath of the last decade's crisis. Although the law has been on the books since 2010, the federal agencies are nowhere near finished writing all the rules associated with the legislation. The sheer vagueness of the situation forces U.S. businesses to spend even more time and money trying to figure out how on Earth to stay in compliance. The enormous uncertainty that this law created has paralyzed entrepreneurship and job creation, exacerbating the very crisis it was aimed at addressing.

Uncertainty is also created by central banks' ad hoc and discretionary policies. The Federal Reserve's repeated attempts to offset consumers' desire to hold on to their money rather than spend it have created major distortions to the capital markets. This imposes serious costs on the economy. Economists, including the Mercatus Center's Scott Sumner, argue that if the government adopted a credible, rules-based monetary policy—promising to raise interest rates by a set amount, no matter what, as inflation increases, for example—it would send a clear signal that would reduce uncertainty and weaken the risk of recessions.

But the truth is that there isn't much the Fed could or should do to fight recessions in the first place. If there is such a thing as a monetary policy that will stimulate growth, the Reason Foundation's Tamny argues "it will come from the U.S. Treasury publicly endorsing a strong and stable dollar." He thinks this will cause a surge in investments into the U.S. from around the world.

Ultimately, though, the most important thing we can do to keep the next recession from wreaking catastrophic damage is to reduce the national debt. According to the St. Louis Federal Reserve Bank, the total public debt is currently above 105 percent of America's gross domestic product. To state that more clearly, the government owes more in bills it can't pay than our entire economy will produce this year. That is a problem, because too much debt makes it hard to respond to emergencies when they do arise.

The way forward is clear: Economists don't agree on much, but the scholarly literature consistently finds that spending cuts are more likely than tax increases to lead to lasting debt reduction. A common worry is that cutting expenditures might reduce overall demand for goods and services and thrust us into an economic slump. But as Harvard economist Alberto Alesina has pointed out, reducing spending is more likely to be associated with economic expansions than recessions. This makes intuitive sense: Fiscal adjustments based on spending cuts demonstrate that a country is serious about getting its house in order. That's an important signal when the economy is strong and an even more important one when it's weak. Higher taxes, on the other hand, nearly always get eaten up through more new spending and do nothing to combat the underlying problem of America's indebtedness.

No amount of fiddling with economic policy can eliminate the possibility of future recessions. The important thing is reacting to them in ways that make us stronger on the other side.