The Recession: Causes and Cures

  • The recession was neither unforeseeable nor inexplicable. On the contrary, it was the direct and unavoidable result of the credit-fuelled boom that preceded it.
  • Governments and their central banks contributed to the boom by: (1) keeping interest rates too low for too long, allowing asset-price bubbles to build; (2) giving implicit guarantees to the banks and other borrowers; (3) failing in their functions of prudential supervision and financial market regulation; and (4) by encouraging borrowing by those least able to afford it.
  • These mistakes originated in a misunderstanding by central bankers and Treasury officials on both sides of the Atlantic of the nature of the economic cycle, and in their consequent hubristic belief that they had solved the problem of how to prevent recessions.
  • The only way to avoid a recession is to restrain the antecedent boom. However, once a recession is under way, there may be ways to mitigate its worst effects and bring it more quickly to an end. The key is to re-establish a climate of business confidence.
  • The best way to do that is to set a long-term course for lower corporate and personal tax rates, and stick to it. In the medium term, higher taxes can only be limited by reducing government expenditure, not by borrowing. Large-scale borrowing does not inspire confidence, because it gives rise to an expectation of future tax rises which discourages investment.
  • In contrast, the three principal measures that have been adopted by the US and UK Governments to mitigate the recession are of marginal benefit and may prove harmful. These are: injecting taxpayers' money into the banks, artificially expanding the money supply, and attempting to provide a 'fiscal stimulus'.
  • While one can understand why Governments felt the need to bail out certain institutions when they did, attempting to bail out all the banks is unwise. An orderly liquidation of the insolvent banks would have left sound banks in a stronger market position, allowing them to expand their lending to creditworthy borrowers more rapidly. No financial institution should be allowed to believe it is too big to fail.
  • Expanding excessively the supply of money is unlikely to have a positive impact. In the long-term, it poses an inflationary threat which may be difficult for central banks to counter.
  • The prescription of an across-the-board fiscal stimulus as a remedy is equally misconceived. The present recession is not the result of a deficiency in aggregate demand which was growing steadily until the summer of 2007. Nor is the recession's impact evenly distributed across the economy. There may be a case for targeted assistance to alleviate hardship and ease adjustment, but government must be careful not to support unsuccessful firms at the expense of successful ones.
  • A notable feature of the boom was the misalignment of incentives in financial markets, which encouraged excessive risk-taking. This is largely attributable to the persistent failure of institutional shareholders to hold directors and senior managers to account. This may perhaps be the biggest flaw in the operation of Western market economies at the present time, and needs to be addressed by legislation.
  • The present crisis has cast into doubt the ability of national governments to control the supply of money and credit. In the short term, new monetary and fiscal policies will have to be formulated. If these don’t work, then in the longer term some form of commodity reserve system for currencies may need to be considered.

In our latest publication, The Recession: Causes and Cures, economist David Simpson examines the current recession and the government's responses to it. I'd highly recommend reading the whole thing if you have time (PDF available here) – the analysis of the financial crisis is one of the best I've read – but for now you can click read more for the executive summary.