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The Great Recession: An Economic Analysis

The end of capitalism has begun. The world spirals deeper into an economic downfall which it will not recover from and it is all because of the capitalistic system. These beliefs were common, uneducated, public opinion on the economy during both the Great Depression and the Great Recession of 2008 (Bartlett, 2009). Although these pessimistic voices of disbelief in the current system had a certain gravity surrounding them, the men and women in charge of making economic decisions worked hard to ensure the economy would recover. The questions that arise are, how exactly was this recovery made?

What has humankind learned from The Great Recession? Were the central bank expansionary monetary policies enacted, truly decisions made with wisdom and rationale? By examining the use of monetary policy in the Great Recession (with focus on G7 countries) one can see the advantages it presented when enacted swiftly and decisively; furthermore, by looking at some of the results the limitations of these policies become quite clear. Lastly, by analyzing fiscal policy maneuvers, it is also observed that fiscal policy can indeed help the economic situation in a deep recession.

Overall, it is undeniable that a mixture of the two policies would be the best way towards economic recovery and well-being in a deep recession such as the 2008 recession. Firstly, expansionary monetary policy is a timely, quick and effective way to help improve and provide immediate relief to the economy during a recession. In 2008, the FED made multiple public announcements, accompanied by swift decisions and explained that expansionary monetary policy can help to prevent an adverse feedback loop. This occurs when a recession creates uncertainty about asset values (valuation risk).

As a result, firms are not confident enough in their financial position to engage in spending and investing activities. Such a situation could lead to greater uncertainty and cause a further deterioration in macroeconomic activity and this continues. This mechanism is also referred to as the financial “accelerator” by economists (Ben Bernanke, Mark Gertler, and Simon Gilchrist, 1999). If a timely, decisive and flexible policy is implemented by decreasing overnight interest rates (and by transmission general rates), the valuation risk decreases and output should remain constant (Mishkin 2008; 2009).

This also devalues domestic currency, increasing output in the exports sector which may indirectly increase GDP. It is also possible the effectiveness of lowering interest rates and expansionary monetary policy is ambiguous and at best presents no difference or causes unnecessary inflation. However, if one analyzes the counter-scenario in which the FED did not reduce rates, it is clear that monetary policy is necessary. In this hypothetical economy, contractionary or unchanged monetary policy would make valuing securities just as difficult as before, in addition to higher uncertainty of credit risk.

Moreover, the restrictions on business investment and consumer spending from such a policy would make the downturn even more severe (Mishkin, 2009). Therefore, not only has monetary policy been effective, but it has proven to be even more potent than in ordinary times because not only did it lower interest rates on government securities, but also helped lower credit spreads. Lastly, there is the concept of the unconventional monetary policy which has proven to be effective, known as quantitative easing (QE).

This is when the central bank purchases assets financed by their reserves. When this is done, the money supply should increase and interest rates should decrease, leading to higher spending and inflation. In a paper examining the effect of QE on the financial market in the United Kingdom, it was found that QE was effective in lowering yields on mid to long term bonds (Michael, Joyce, Lasosa, Stevens and Tong, 2011). This method was also useful in the United States at lowering nominal interest rates and the corporate credit risk (Krishnamurthy and Jorgensen, 2011).

However, even Mishkin himself admits that, “The financial crisis has led to such a widening of credit spreads and tightening of credit standards, that aggressive monetary policy easing has not been enough to contain the crisis” (Mishkin, 2009). Unfortunately, monetary policy does have its limitations. The first limitation arises from something known as the zero-bound limit. Interest rates cannot go below zero in conventional monetary policy. Additionally, in the band around zero, the effectiveness of monetary policy decreases. This is because consumers and firms alike choose to save their money.

The reasoning behind avoiding bonds and investing is that interest rates will soon rise. As a result, bonds will devalue and hence consumers do not wish to hold bonds. This is known as the liquidity trap (Blanchard, 2000; Eggertsson, Gauti and Michael Woodford, 2003). Also, drawing a parallel with the U. S to Japan, it is seen that lowering interest rates has little to no effect when rates are near zero. This is proven when Donner and Peters say, “Since interest rates could not fall below zero, Japanese monetary policy proved nearly impotent” (Donner and Peters, 2010).

In recent times, an idea to solve this problem proposes applying negative interest rates to overnight deposits. However, one can present the argument that in Japan, Sweden and Switzerland negative rates have not done much to increase growth. They have, at best, caused a decrease in foreign investment (into bonds), decreased demand for currency and created a devalued domestic currency. This may make the exports industry more productive, but when one factors in the downsides of negative rates, the overall effect is uncertain (Irwin, 2016).

Lastly, especially in the case of The Great Recession, there is the ‘Balance Sheet Recession’. In this recession, since assets rapidly devalue, household balance sheets are underwater. This results in individuals changing their behaviour where instead of borrowing more money, investing or spending, they save and pay off their debt. Therefore, at any given interest rate, borrowing will not increase and the economy will stay stagnant (Koo, 2015). These limitations and failures of monetary policy are evidence that Keynes’ ideology of using fiscal policy in a deep recession is correct (Krugman, 2009).

Consequently, the truth is that monetary policies accompanied by fiscal stimulus is the most efficient and stable form of response in order to resolve both the overall recession as well as the damaged balance sheets of households and firms. Another form of repairing a damaged economy is fiscal policy. In the great work done by Keynes, he highlighted the paramount fact that in a liquidity trap, the most relevant policy instrument is fiscal policy (Donner and Peters, 2010). Furthermore, real-world evidence of Japan has shown that fiscal policy can be used to keep GDP from falling (Koo, 2015).

Japan was able to recover from their deadly balance sheet recession, kept GDP higher than pre-crisis, living standards only improved and unemployment levels remained relatively constant. Now that it has been established fiscal policy should be utilized, what exactly would constitute as an effective use of fiscal policy in the economic state of The Great Recession? Many economists believe infrastructure is simply the best investment for fiscal policy (Hodgson and Antunes, 2015).

This is because infrastructure returns future cash flows and stimulates spending more than other forms of fiscal policy. In the results from Canada’s 2008 fiscal stimulus package show the infrastructure multiplier was, “1. 5 per cent in 2010, whereas business tax cuts only produced a multiplier of 0. 2 per cent” (Curry and Mckenna, 2010). Lastly, it is absolutely crucial to ensure not to remove these fiscal stimulus packages before private sector balance sheets have fully repaired; this would result in a double-dip recession, much like the U. S in 1937, Japan in 1997 and the Eurozone in 2010 (Koo, 2015).

In conclusion, tools like monetary policy need to be understood as mutual and not exclusive tools to solve economic issues like The Great Recession. Without immediate monetary policy relief, there would be higher valuation risks and due to this an overall increase in macroeconomic relief. Furthermore, low interest rates tend to increase borrowing, spending and investment in the economy under ordinary circumstances. Also, this can indirectly increase GDP through the exporting sector by devaluing domestic currency.

As substantial as monetary policy may sound, it does have limitations; these were exposed in The Great Recession. Liquidity traps, Balance-sheet recessions and the unproven use of negative interest rates are all reasons why monetary policy alone cannot contain the crisis. In order to supplement these downfalls there is hope in the form of fiscal policy. Business tax cuts have shown not to be as promising for overall economic well-being, whereas targeted and rapid investment in infrastructure has had major positive effects.

Together, the mixture of these two in the past has shown to be the most effective way to deal with economic crises such as The Great Recession. The future benefits of learning how to handle such a dramatic and massive downturn of the economy are vast. If the correct individuals are able to learn from the policies that have been and should be enacted, the economic future is bright and never-ending. There is no room for error when one is dealing with policies that affect billions of people and their standard of living. It is ever more significant now to deliberate on the past, learn from mistakes and focus on the future.

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