Monday, August 22, 2011

Financial Crises vs. Typical Recessions

To understand what's going on in today's economy, you must recognize that we haven't experienced a normal recession, but instead it was caused by a financial crisis.  For those who follow economics, you're probably well aware of the research performed by Ken Rogoff and Carmen Reinhart ("This time is different").  Bascially, people accumulate a lot of debt as their perceived wealth increases (in this case, their primary asset, their house, increases in value).  At some point, the bubble bursts and their wealth declines but their debt remains.  Consumers need to spend years deleveraging to get their finances in order, thus consumer spending remains constrained.  Meanwhile, the financial system is severely damaged as many loans are not repaid, thus lending becomes tight for an extended period of time.  A substantial portion of the economy needs to undergo structural adjustment as it had become too focused on producing goods and services related to the bubble (housing) and needs to shed jobs and production in those areas and find new productive areas.  However, with a damaged financial system, it's difficult to finance new businesses (for example, small businesses who had relied on home equity lines of credit no longer have home equity or lines of credit).  Add it up and you have a deep downturn followed by a weak recovery.

What about government?  Budget deficits and the national debt increase significantly due to the economic downturn (government collects less tax revenue due to declining incomes, etc., and automatically spends more on programs associated with increased unemployment and increased poverty).  Other factors contribute to the rise in the national debt, including stimulus programs (whether tax cuts or spending increases).  Given the extended nature of the economic weakness, the deficit remains high and the national debt soars.  At some point, the government reaches a limit in terms its ability to provide further stimulus.  In the case of the US, add to that the increase in entitlement spending due in part to the retirement of baby boomers (for example, medicare) and the debt becomes a crisis.  The focus shifts from economic stimulus to reigning in excessive debt.

That's a quick overview of where we stand today.  Details will be explored in future posts.