| Recessions happen when people cash to any | | | | believe otherwise. Wherever there is money, |
| other type of asset or investment. | | | | human psychology is in operation and with it |
| The fate of modern economies is determined by | | | | economic malaise. Hence the need for |
| four types of demand: the demand for consumer | | | | governmental micromamangement of the private |
| goods; the demand for investment goods; the | | | | sector at all times. Self-regulation is a costly and |
| demand for money; and the demand for assets, | | | | self-deceiving urban legend. |
| which represent the expected utility of money | | | | Another engine of state involvement is provided |
| (deferred money). | | | | by the thrift paradox. When the economy goes |
| Periods of economic boom are characterized by a | | | | sour, rational individuals and households save more |
| heightened demand for goods, both consumer | | | | and spend less. The aggregate outcome of their |
| and investment; a rising demand for assets; and | | | | newfound thrift is recessionary: decreasing |
| low demand for actual money (low savings, low | | | | consumption translates into declining corporate |
| capitalization, high leverage). | | | | profitability and rising unemployment. These |
| Investment booms foster excesses (for instance: | | | | effects are especially pronounced when financial |
| excess capacity) that, invariably lead to | | | | transmission mechanisms (banks and other |
| investment busts. But, economy-wide recessions | | | | financial institutions) are gummed up: frozen in fear |
| are not triggered exclusively and merely by | | | | and distrust, they do not lend money, even |
| investment busts. They are the outcomes of a | | | | though deposits (and their own capital base) are |
| shift in sentiment: a rising demand for money at | | | | ever growing. |
| the expense of the demand for goods and | | | | It is true that, by diversifying risk away, via the |
| assets. | | | | use of derivatives and other financial instruments, |
| In other words, a recession is brought about | | | | asset markets no longer affect the real economy |
| when people start to rid themselves of assets | | | | as they used to. They have become, in a sense, |
| (and, in the process, deleverage); when they | | | | "gated communities", separated from Main Street |
| consume and lend less and save more; and when | | | | by "risk barriers". But, these developments do not |
| they invest less and hire fewer workers. A | | | | pertain to retail banks and when markets are |
| newfound predilection for cash and | | | | illiquid and counterparty risk rampant, options |
| cash-equivalents is a surefire sign of impending | | | | and swaps are pretty useless. |
| and imminent economic collapse. | | | | The only way to effectively cancel out the this |
| This etiology indicates the cure: reflation. Printing | | | | demonetization of the national economy (this |
| money and increasing the money supply are | | | | "bleeding") is through enhanced government |
| bound to have inflationary effects. Inflation ought | | | | spending. Where fearful citizens save, their |
| to reduce the public's appetite for a depreciating | | | | government should spend on infrastructure, |
| currency and push individuals, firms, and banks to | | | | health, education, and information technology. The |
| invest in goods and assets and reboot the | | | | state's negative savings should offset multiplying |
| economy. Government funds can also be used | | | | private savings. In extremis, the state should |
| directly to consume and invest, although the | | | | nationalize the financial sector for a limited period |
| impact of such interventions is far from certain. | | | | of times (as Israel has done in 1983 and Sweden, |
| GOVERNMENTS | | | | a decade later). |
| It is a maxim of current economic orthodoxy that | | | | A Note on GDP (Gross Domestic Product) |
| governments compete with the private sector on | | | | The formula to calculate GDP is this: |
| a limited pool of savings. It is considered equally | | | | GDP (Gross Domestic Product) = |
| self-evident that the private sector is better, | | | | Consumption + investment + government |
| more competent, and more efficient at allocating | | | | expenditure + net exports (exports minus |
| scarce economic resources and thus at | | | | imports) = |
| preventing waste. It is therefore thought | | | | Wages + rents + interest + profits + non-income |
| economically sound to reduce the size of | | | | charges + net foreign factor income earnedBut |
| government - i.e., minimize its tax intake and its | | | | the GDP figure is vulnerable to "creative |
| public borrowing - in order to free resources for | | | | accounting": |
| the private sector to allocate productively and | | | | 1. The weight of certain items, sectors, or |
| efficiently. | | | | activities is reduced or increased in order to |
| Yet, both dogmas are far from being universally | | | | influence GDP components, such as industrial |
| applicable. | | | | production. Developing countries often alter the |
| The assumption underlying the first conjecture is | | | | way critical components of GDP like industrial |
| that government obligations and corporate lending | | | | production are tallied. |
| are perfect substitutes. In other words, once | | | | 2. Goods in inventory are included in GDP although |
| deprived of treasury notes, bills, and bonds - a | | | | not yet sold. Thus, rising inventories, a telltale sign |
| rational investor is expected to divert her savings | | | | of economic ill-health, actually increases the GDP! |
| to buying stocks or corporate bonds. | | | | 3. If goods produced are financed with credits and |
| It is further anticipated that financial intermediaries | | | | loans, GDP will be artificially HIGH (inflated). |
| - pension funds, banks, mutual funds - will tread | | | | 4. In some countries, PLANS and INTENTIONS to |
| similarly. If unable to invest the savings of their | | | | invest are counted, recorded, and booked as |
| depositors in scarce risk-free - i.e., government - | | | | actual investments. This practice is frowned upon |
| securities - they will likely alter their investment | | | | (and landed quite a few corporate managers in |
| preferences and buy equity and debt issued by | | | | the gaol), but is still widespread in the shoddier and |
| firms. | | | | shadier corners of the globe. |
| Yet, this is expressly untrue. Bond buyers and | | | | 5. GDP figures should be adjusted for inflation (real |
| stock investors are two distinct crowds. Their risk | | | | GDP as opposed to nominal GDP). To achieve |
| aversion is different. Their investment | | | | that, the calculation of the GDP deflator is critical. |
| preferences are disparate. Some of them - e.g., | | | | But the GDP deflator is a highly subjective figure, |
| pension funds - are constrained by law as to the | | | | prone, in developing countries, to reflecting the |
| composition of their investment portfolios. Once | | | | government's political needs and predilections. |
| government debt has turned scarce or expensive, | | | | 6. What currency exchange rates were used? By |
| bond investors tend to resort to cash. That cash | | | | selecting the right "points in time", GDP figures can |
| - not equity or corporate debt - is the veritable | | | | go up and down by up to 2%! |
| substitute for risk-free securities is a basic tenet | | | | 7. Healthcare expenditures, agricultural subsidies, |
| of modern investment portfolio theory. | | | | government aid to catastrophe-stricken areas |
| Moreover, the "perfect substitute" hypothesis | | | | form a part of the GDP. Thus, for instance, by |
| assumes the existence of efficient markets and | | | | increasing healthcare costs, the government can |
| frictionless transmission mechanisms. But this is a | | | | manipulate GDP figures. |
| conveniently idealized picture which has little to do | | | | 8. Net exports in many developing countries are |
| with grubby reality. Switching from one kind of | | | | negative (in other words, they maintain a trade |
| investment to another incurs - often prohibitive - | | | | deficit). How can the GDP grow at all in these |
| transaction costs. In many countries, financial | | | | places? Even if consumption and investment are |
| intermediaries are dysfunctional or corrupt or | | | | strongly up - government expenditures are usually |
| both. They are unable to efficiently convert | | | | down (at the behest of multilateral financial |
| savings to investments - or are wary of doing so. | | | | institutions) and net exports are down. It is not |
| Furthermore, very few capital and financial | | | | possible for GDP to grow vigorously in a country |
| markets are closed, self-contained, or | | | | with a sizable and ballooning trade deficit. |
| self-sufficient units. Governments can and do | | | | 9. The projections of most international, objective |
| borrow from foreigners. Most rich world countries | | | | analysts and international economic organizations |
| - with the exception of Japan - tap "foreign | | | | usually tend to converge on a GDP growth figure |
| people's money" for their public borrowing needs. | | | | that is often lower than the government's but in |
| When the US government borrows more, it | | | | line with the long-term trend. These figures are |
| crowds out the private sector in Japan - not in | | | | far better indicators of the true state of the |
| the USA. | | | | economy. Statistics Bureaus in developing |
| It is universally agreed that governments have at | | | | countries are often under the government's |
| least two critical economic roles. The first is to | | | | thumb and run by political appointees. |
| provide a "level playing field" for all economic | | | | EXPECTATIONS |
| players. It is supposed to foster competition, | | | | Economies revolve around and are determined by |
| enforce the rule of law and, in particular, property | | | | "anchors": stores of value that assume pivotal |
| rights, encourage free trade, avoid distorting fiscal | | | | roles and lend character to transactions and |
| incentives and disincentives, and so on. Its second | | | | economic players alike. Well into the 19 century, |
| role is to cope with market failures and the | | | | tangible assets such as real estate and |
| provision of public goods. It is expected to step in | | | | commodities constituted the bulk of the |
| when markets fail to deliver goods and services, | | | | exchanges that occurred in marketplaces, both |
| when asset bubbles inflate, or when economic | | | | national and global. People bought and sold land, |
| resources are blatantly misallocated. | | | | buildings, minerals, edibles, and capital goods. These |
| Yet, there is a third role. In our post-Keynesian | | | | were regarded not merely as means of |
| world, it is a heresy. It flies in the face of the | | | | production but also as forms of wealth. |
| "Washington Consensus" propagated by the | | | | Inevitably, human society organized itself to |
| Bretton-Woods institutions and by development | | | | facilitate such exchanges. The legal and political |
| banks the world over. It is the government's | | | | systems sought to support, encourage, and |
| obligation to foster growth. | | | | catalyze transactions by enhancing and enforcing |
| In most countries of the world - definitely in | | | | property rights, by providing public goods, and by |
| Africa, the Middle East, the bulk of Latin America, | | | | rectifying market failures. |
| central and eastern Europe, and central and east | | | | Later on and well into the 1980s, symbolic |
| Asia - savings do not translate to investments, | | | | representations of ownership of real goods and |
| either in the form of corporate debt or in the | | | | property (e.g, shares, commercial paper, |
| form of corporate equity. | | | | collateralized bonds, forward contracts) were all |
| In most countries of the world, institutions do not | | | | the rage. By the end of this period, these |
| function, the rule of law and properly rights are | | | | surpassed the size of markets in underlying |
| not upheld, the banking system is dysfunctional | | | | assets. Thus, the daily turnover in stocks, bonds, |
| and clogged by bad debts. Rusty monetary | | | | and currencies dwarfed the annual value added in |
| transmission mechanisms render monetary policy | | | | all industries combined. |
| impotent. | | | | Again, Mankind adapted to this new environment. |
| In most countries of the world, there is no | | | | Technology catered to the needs of traders and |
| entrepreneurial and thriving private sector and the | | | | speculators, businessmen and middlemen. |
| economy is at the mercy of external shocks and | | | | Advances in telecommunications and |
| fickle business cycles. Only the state can counter | | | | transportation followed inexorably. The concept of |
| these economically detrimental vicissitudes. Often, | | | | intellectual property rights was introduced. A |
| the sole engine of growth and the exclusive | | | | financial infrastructure emerged, replete with highly |
| automatic stabilizer is public spending. Not all types | | | | specialized institutions (e.g., central banks) and |
| of public expenditures have the desired effect. | | | | businesses (for instance, investment banks, |
| Witness Japan's pork barrel spending on | | | | jobbers, and private equity funds). |
| "infrastructure projects". But development-related | | | | We are in the throes of a third wave. Instead of |
| and consumption-enhancing spending is usually | | | | buying and selling assets one way (as tangibles) or |
| beneficial. | | | | the other (as symbols) - we increasingly trade in |
| To say, in most countries of the world, that | | | | expectations (in other words, we transfer risks). |
| "public borrowing is crowding out the private | | | | The markets in derivatives (options, futures, |
| sector" is wrong. It assumes the existence of a | | | | indices, swaps, collateralized instruments, and so |
| formal private sector which can tap the credit and | | | | on) are flourishing. |
| capital markets through functioning financial | | | | Society is never far behind. Even the most |
| intermediaries, notably banks and stock | | | | conservative economic structures and institutions |
| exchanges. | | | | now strive to manage expectations. Thus, for |
| Yet, this mental picture is a figment of economic | | | | example, rather than tackle inflation directly, |
| imagination. The bulk of the private sector in | | | | central banks currently seek to subdue it by |
| these countries is informal. In many of them, | | | | issuing inflation targets (in other words, they aim |
| there are no credit or capital markets to speak | | | | to influence public expectations regarding future |
| of. The government doesn't borrow from savers | | | | inflation). |
| through the marketplace - but internationally, | | | | The more abstract the item traded, the less |
| often from multilaterals. | | | | cumbersome it is and the more frictionless the |
| Outlandish default rates result in vertiginously high | | | | exchanges in which it is swapped. The smooth |
| real interest rates. Inter-corporate lending, barter, | | | | transmission of information gives rise to both |
| and cash transactions substitute for bank credit, | | | | positive and negative outcomes: more efficient |
| corporate bonds, or equity flotations. As a result, | | | | markets, on the one hand - and contagion on the |
| the private sector's financial leverage is minuscule. | | | | other hand; less volatility on the one hand - and |
| In the rich West $1 in equity generates $3-5 in | | | | swifter reactions to bad news on the other hand |
| debt for a total investment of $4-6. In the | | | | (hence the need for market breakers); the |
| developing world, $1 of tax-evaded equity | | | | immediate incorporation of new data in prices on |
| generates nothing. The state has to pick up the | | | | the one hand - and asset bubbles on the other |
| slack. | | | | hand. |
| Growth and employment are public goods and | | | | Hitherto, even the most arcane and abstract |
| developing countries are in a perpetual state of | | | | contract traded was somehow attached to and |
| systemic and multiple market failures. Rather than | | | | derived from an underlying tangible asset, no |
| lend to businesses or households - banks thrive on | | | | matter how remotely. But this linkage may soon |
| arbitrage. Investment horizons are limited. Should | | | | be dispensed with. The future may witness the |
| the state refrain from stepping in to fill up the gap | | | | bartering of agreements that have nothing to do |
| - these countries are doomed to inexorable | | | | with real world objects or values. |
| decline. | | | | In days to come, traders and speculators will be |
| In times of global crisis, these observations pertain | | | | able to generate on the fly their own, |
| to rich and developed countries as well. Market | | | | custom-made, one-time, investment vehicles for |
| failures signify corruption and inefficiency in the | | | | each and every specific transaction. They will do |
| private sector. Such misconduct and misallocation | | | | so by combining "off-the-shelf", publicly traded |
| of economic resources is usually thought to be | | | | components. Gains and losses will be determined |
| the domain of the public sector, but actually it | | | | by arbitrary rules or by reference to extraneous |
| goes on eveywhere in the economy. | | | | events. Real estate, commodities, and capital |
| Wealth destruction by privately-owned firms is | | | | goods will revert to their original forms and |
| typical of economies with absent, lenient, or lax | | | | functions: bare necessities to be utilized and |
| regulation and often exceeds anything the public | | | | consumed, not speculated on. |
| administration does. Corruption, driven by avarice | | | | Also Read |
| and fear, is common among entrepreneurs as | | | | Governments and Growth |
| much as among civil servants. It is a myth to | | | | Is Education a Public Good? |