How to End the Recession

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The macroeconomics that most of us learned in college offered two major schools of thought on how to end a recession.  The Keynesians said massive government spending (“stimulus”) is the solution to create a recovery.  The Monetarists claimed that expanding the money supply will cure the recession.  Today, I will tell you why both schools of economic thought are wrong, and lay out a plan to get the U.S economy out of recession.  In the process, you will see why the President would be better served if he fired his economic team and replaced it with one containing a few business valuation experts.

 

First, the cold hard facts.  The economy grew at a 1.6% rate this spring, down from an initial estimate of 2.4%.  That is a terrible performance for an economy that is supposed to be in recovery, where normally you would expect recovery growth rates in excess of 5%.  Housing sales fell 27% in July, and the stock market is down for the year.  For those who think the stock market predicts future trends for the economy, the “Hindenburg Omen” is predicting a stock market crash and burn.  Unemployment remains extraordinarily high, around 9.5% officially and over 17% if you adjust for the government’s careful manipulation of the term “unemployed”.  In short, the economy looks like it could go back in recession, if it ever came out of it in the first place.

 

The Keynesian’s view is that the recession is due to a fall in consumption, and their prescription has been massive stimulus spending.  First we had the Bush $250 billion “rebate checks” stimulus and then the massive $800 billion Obama “pork barrel” stimulus.  Stimulus spending has failed to create a recovery because it mistakes the root of the problem.  Recessions are not caused by a fall in consumption; they are caused by a fall in investment spending.  If you doubt me, here is the Vice Chairman of the Federal Reserve stating that investment is the key to the business cycle:

"Although it makes up only about 10 percent of gross domestic product, business investment is a vital element of the U.S. economy, with important implications for a variety of broader economic issues.

Investment has a large influence on the year-to-year fluctuations in economic activity. During the past six recessions, the drop in domestic investment has generally accounted for most of the decline in GDP [emphasis added].  Business investment was a major factor in both the 1990s economic expansion and the subsequent recession. In fact, the decline in business outlays on investment goods in 2001 was even larger than the downturn in the overall economy. Although overall GDP edged down at an average annual rate of only 0.2 percent in the first three quarters of 2001, the decline in business investment subtracted nearly 2 percentage points from GDP growth over that period. Clearly, some insight into investment swings would enable us to better understand the economic cycles of recessions and expansions, which in turn have such a big effect on job creation, the budget deficit, and a host of other important issues.

Business investment also affects the broader economy through labor productivity--or output per hour of work. Over the past fifty years, the average hourly output of American workers has increased nearly 200 percent. According to the Bureau of Labor Statistics, more than one-third of this improved efficiency likely reflects increases in the use of capital goods. Over the past decade, efficiency gains due to increased capital expenditures have been especially pronounced. Because rising productivity is the primary means through which standards of living increase, capital investment is clearly an important part of the economic engine. Accordingly, an understanding of investment is critical for insight into both cyclical and longer-run economic developments."
http://www.federalreserve.gov/boarddocs/speeches/2004/20041026/default.htm

 

From the Fed Vice Chairman’s comments it is clear that  the primary factor that puts an economy into recession is a decline in investment spending, not consumption spending. Likewise investment spending is the factor that lifts an economy into recovery. When businesses invest in new plant and equipment they lower their costs and are able to make larger profits on the lower prices that exist in a recession. When they make larger profits, they hire more people and the recovery commences.

Therefore the "stimulus" policies pursued by the Federal government will not work. Giving people "rebate checks” is a very economically inefficient way to stimulate business investment.  Even enormous amounts spend on consumer stimulus will not work because they do very little to improve productivity and raise income, and people know that the stimulus will have to be repaid with higher taxes on future income down the road.

Government spending stimulus (classical Keynesian stimulus) will also not work because diverting trillions from the productive economy into government bailouts and spending programs is a misallocation of resources that decreases productivity instead of raising it. The government cannot allocate spending more efficiently than the market economy, hence the decreased productivity.  Moreover this spending has to be paid for, so in the short term it is done by borrowing all the capital that should be available to private companies, and in the long term it is paid for with higher taxes, which lower business profitability, leading to job losses.

 

In other words, Keynesian “stimulus” is like giving someone who needs a blood transfusion a bottle of Jolt cola instead.  After the sugar and caffeine rush, a crash follows because the cola did nothing to improve the underlying health of the patient.  Government borrowing and spending is only simulative if it increases productivity and therefore personal and business income more than the increased future taxes needed to repay the borrowing.  Besides, the Chinese are not going to keep lending us the money forever; in fact they are trying to reduce their holdings of US Treasuries.

 

The reason the Monetarist solution won’t work either is more subtle.  Under normal economic conditions, the Federal Reserve can cause a recession by raising real interest rates and contracting the growth of the money supply.  The Federal Reserve can lift the economy out of a recession by lowering real interest rates and increasing money growth.  It is important to understand how this works.  It is not some sort of “Monetary Magic”.  Money manipulations only work if the monetary moves translate into business investment spending on physical capital goods.  As all business valuation experts know, higher interest rates decrease the present value of business investments, reducing investment. Lower interest rates increase the present value of business investment projects, making more projects viable.

 

The problem with the Monetarist’s prescription for the economy is that interest rates are at historic lows, and business investment has not increased.  Conditions are not normal.  Business investment is not increasing because businesses are not anticipating higher future income from investment.  The reason is simple; businesses know the government is planning massive tax increases to fund its deficit spending.  At the end of this year, the income tax rates will be increased.  (There will also be massive tax increases to fund the national healthcare program, and if cap and trade is passed, there will be massive tax increases on energy as well). 

 

Business valuation experts know that increasing personal income taxes directly impacts the profitability of LLCs and partnerships.  The decrease in after-tax income will cause the owners of small businesses to reduce staffing and operating costs in an attempt to maintain their personal after-tax income.  Thus the Monetarist policy will fail, as businesses reduce investment spending, and interest rates cannot be lowered much further.  The Fed is “pushing on a string.”  Or as the Keynesians would say, the Monetarists are caught in the “liquidity trap”.

 

So how do we end the recession and get back to normal growth quickly if both Keynesian and Monetarist policies are failing?  The key driver to focus on is increasing business investment.  As the Federal Reserve itself stated, the swing factor in a recession is primarily investment, not consumption. So you have to get business investment going again. Concentrating on something other than business investment is like trying to fix your car's transmission by changing the tires.

Why do businesses invest in new capital equipment? Two reasons: (1) to improve productivity of existing plants so profits increase, and (2) to expand capacity so profits increase. That is why investment tax credits for business have always worked to get the US out of recession, and worked spectacularly well to get us out of the 1982 recession.

Initially people will invest in new equipment for their EXISTING plants and offices, making their companies more efficient and thus restoring the lost profitability due to the recession. Companies will make this investment if an investment tax credit frees up cash and makes it affordable. This investment will create a sales boom for capital equipment providers, who then hire more people. In addition, as profitability is restored to the rest of American industry, companies can afford to give pay raises again, which stimulates consumption demand as well. That is when reason #2 for investing kicks in. But the process starts with reason #1, business investment to improve the productivity and thus the profitability of existing plants.   Why does this work? Because you need to restore profits to get out of a recession. Profits enable businesses to buy new equipment, hire workers and eventually expand their businesses.   

 

Another part of increasing the profitability of American business is preventing the huge tax increases scheduled for 2011.  Just as investment tax credits lower the cost of investment spending, preventing large tax increases on small businesses is crucial to maintain the return on investment spending.  It is time to dump the “soak the rich” rhetoric, because in most cases what it really means is “soak small businesses.”

 

The final item in the recovery program is a major cutback in Federal spending.  Humongous deficits necessarily mean higher future taxes, which discourages business investment and prolongs recessions.  In 2007, the Federal budget had revenues of $2.57 trillion with spending of $2.73 trillion.

http://www.cbo.gov/ftpdocs/100xx/doc10014/March2009_HistoricalTables.pdf

 

For 2010, the Federal budget estimates revenues of $2.38 trillion, but spending has increased to $3.55 trillion! 

http://en.wikipedia.org/wiki/2010_United_States_federal_budget

 

Thus the fall in tax revenues from the recession accounts for only a small part of the over $1 trillion dollar deficit, most of it is a binge of increased spending.  It is reasonable and prudent to cut spending back to 2007 levels.  It would not be the end of the world.

 

So the way to end the recession is summarized as follows:

  1. Direct incentives and tax credits to increase business investment.
  2. Repeal the huge income tax increases scheduled for 2011.
  3. Cut Federal spending back to 2007 levels.

One more thing, stop demonizing companies for making profits.  Profits are GOOD. Rising profits lead to business investment, business expansion, more jobs and a quicker economic recovery.

 

 

 

 

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How is an increase in only investment spending going to help us out of a recession if there are no consumers willing to spend their savings? Don't you think there should distribution among investors as well as consumers? If there investors creating a good and/or service they have to have someone to consume their goods and/or services. Or are you assuming the increased investment spending, thus increased employment will provide wages with which consumers can spend?