My Ten Cents

Monday, October 17, 2016

Economic Recession: Causes, Effects, and Possible Solutions

Economists generally believe that recessions occur due to a more than normal drop in spending by both the private and public sectors; some of the causes this drop include financial crises, as was the case in 2008 when the world suffered the consequences of a global financial meltdown due, in part, to the burst of the US housing bubble; an external trade or adverse supply shock – for example, some OPEC member countries like Nigeria and Venezuela who were heavily impacted by the drop in crude prices, which led to about 50% drop in revenue and, consequently, resulting in a drop in importation of some critical consumer goods, seem to be sliding into economic recession. The situation is further exacerbated where a nation could not produce enough of these consumer goods locally to offset the shortfall in importation. Some of the consequences of a recessed economy include the following:

Effects on Employment
One of the consequences of recession is unemployment which tends to increase, especially among the low-skilled workers, due to companies and even government agencies laying off staff in order to curtail expense. Unfortunately, this results in further restriction in overall spending which is needed to pull the economy out of recession. Where family or individual income is drastically reduced due to loss of employment or underemployment, discretionary spending, or disposable income, is mostly eliminated in the budget. This reduction in income, in turn, results in non-payment, or delayed payment of debt obligations – especially credit cards - which further reduces the funds available for financial institutions to lend out to businesses for expansion/investment to increase production. Investments which could have resulted in increased employment, income, and discretionary spending that could help pull the nation out of recession.

Effects on Businesses
Another consequence of recession is fall in output or productivity and business closures. The fall in output may to last until weaker companies close shop; eventually, output picks up again among the surviving firms. During recessions, stronger companies tend to swallow up weaker and smaller ones, and this negatively affects the competitive environment; some level of product scarcity, artificial or real – begins to emerge, and prices of goods creep up in response. These mergers or outright acquisitions also result in job losses; thereby, further depressing family incomes, and reducing discretionary spending that is needed to combat recession. A combination of job losses, scarcity of goods, and increased prices, help drives families further into economic difficulties.

Effects on Society
With more people out of work, and families increasingly unable to make ends meet, the pressure on demands for government-funded social services increases. Since governments experience drops in revenue collection during recession (something that, in some cases, lead to the recession in the first place), it becomes difficult to meet the increased demands on social services. Worst hit are those who are either on fixed income – social security checks –, or on Medicaid, and Medicare services (the elderly and disabled). Unlike those on wages and salaries who experience little or no reductions in salaries, the fixed income earners usually see experience cuts in their benefits and services provided by the government, and these cuts increase the level of hardship these families are already feeling. Another, and probably the most devastating, social effect of economic recession is destabilization of families. With the loss of a job, every plan for the future – college education, home purchase, vehicle replacement, and other family-enhancing plans are all suspended, and may never be reactivated or achieved.

All of the above enumerated effects of an economic recession father exacerbates the situation the longer it lasts. It is more of a vicious cycle – a cause-and-effect; effect-and-cause situation. Now, how does a nation get itself out of an economic recession?

Tax cuts & Government Spending
The most popular, or most recommended, policy for any country to dig itself out of recession is expansionary fiscal policy, or fiscal stimulus. This is usually a two-pronged approach – tax cuts and increased government spending. Let us address these two approaches separately:
1.      Tax cuts: the idea of tax cuts in times of recession is to increase family disposable income, in the hope that these families will go out and spend the extra money which, it return, will spur increased production in companies; the increased production is expected to result in increased hiring, and so on, and so forth. Sounds all too simple and wonderful. But, is it that simple? We must remember that in periods of recession, families borrow money, either from financial institutions or their credit cards, to stay afloat. Now, suppose they elect to use the extra disposable income from tax cuts to pay off these accrued debts, how does that help achieve the government’s expected goals increasing consumer spending? While one could argue that the financial institutions will lend the extra revenue (paid loans and credits) to businesses for investment; the question is: how many financial institutions make loans in recession?
2.      Increased government spending: this is more advocated than tax cuts; however, since most of government revenue is generated through taxes, levies, and duties on imports and exports, the receipts from these sources usually diminish in recessive economic periods, because many companies are closing shop and the few that remain open are cutting cost by decreasing staff and output. So, where is government expected to get the money it is supposed to invest in these capital projects? Yes, it is true that government capital investments injects money directly into the economy through creation of massive employment and its attendant multiplier effect, and construction of infrastructure, like roads, rail, ports, etc., which have direct impact on economic growth; but the money has to be available in the first place. Since tax cuts result in reduced government revenue, the only other recourse is external borrowing. This only works, or makes sense, if the money is directed at the right capital investment for the purpose of creating employment and causing a multiplier effect in the economy. For example, the Nigerian government believes that massive investment in agriculture will make the country less dependent on oil revenue; so, it might make sense to invest any external borrowing on agriculture. However, if you invest on cultivation and harvesting of raw products without any investment on the secondary, and more prosperous, segment of agriculture (processed goods for export), then the revenue generated may not be adequate for use in repayment of the loan, and reinvestment in other segments of other sectors of the economy. So, it is not so much about where you invest the loan, but how you do so.

Currency Devaluation
Apart from the two above, devaluation of the local currency is another suggestion usually put forward by economists. A currency devaluation is expected to cause a boost in aggregate demand of goods and services; that is, if the nation produces what other nations need. For industrialized nations with diversified economies and multiple products, a currency devaluation in periods of recession will be beneficial to export products; for nations with mono-product economies, like some African nations, currency devaluation will not have much positive impact in times of international supply glut. So, even though the product will be cheaper to export, the market may not be available. Now, the other effect of devaluation is to increase demand for domestic goods. Where such goods are produced domestically, this plan will work; but, where the absence is the case, then the purpose of currency devaluation is roundly defeated. It is very difficult for most Third World economies to get out of recession through currency devaluation, because they are mostly mono-product economies with devastating international competition, and little diversified domestic production. One thing to keep in mind with devaluation in mono-product economies is that the likelihood of competitive devaluation – in an attempt to gain competitive edge – does exist. For example, suppose that in a global recession Nigeria decides to devalue its currency to boost oil export, the expectation that Angola, Venezuela, and many other oil-dependent economies will follow suit is very real. In the end the market is flooded with cheap oil that no one want; so, everyone suffers from this policy decision, instead of benefiting.

Quantitative Easing
This is a policy applied by central banks to increase/decrease money supply when interest rates are already at, or near, zero. When all other options are exhausted, or in addition to the option earlier enumerated, central banks can manipulate the money supply by buying government bonds to increase the volume money in circulation. This increases bank reserves which will, in theory, encourage banking lending to businesses. The other effect of this central bank action is a reduction in bond interest rates, which is expected to help increase investment spending. Some of the drawbacks, or dangers, of quantitative easing are possibilities of financial losses by the central bank, difficulty in gauging exactly how much money in needed for injection into the economy, likelihood of loss of confidence in the economy -especially by external investors-, and the danger of the plan not working out as intended.

Conclusion

What tool(s) or option(s) a government elects to use to get its economy out of recession depends on what caused the recession in the first place, and which one will have the most minimal adverse impact on the people, or drive the economy deeper into recession or outright depression; but, it must choose something. In choosing, it must also consider the areas or regions of the nation, or section of the economy where the option will work best, especially in terms of fiscal stimulus policy. Which regions of the nation, or segments of the economy, will a fiscal stimulus generate the most multiplier effect? Also, which policy will have the most immediate impact on the economy, tax cuts, fiscal stimulus, credit relaxation, or quantitative easing? It is important to consider all of these before choosing an option, or a combination of options.
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