Recession, Inflations over time

• Throughout 1800s to the present, recessions, hyperinflations, stagflation plagued the global economy as well as individual economies in the world.

• But the mainstream economists continued to believe that the private/ market system had a self-adjusting mechanism to go back to the normal ‘equilibrium?’ 

• But the global Great Depression that lasted a whole decade 1929-1939 opened the eyes of some intelligent economists that the market is not that miraculous and self-adjusting.

• John Meynard Keynes was the important person who emerged, who simply used logic, not insufferable mathematics and calculus (he himself was a mathematician).

A very practical non-market view of recession:  John Meynard Keynes

• Keynes argument was very obvious:

  • The reason for most recessions is a fall in economic confidence in the system – stock market crash as in 1929,  banking loan defaults leading to bank failures in 2008-9 and many other crises. Now the covid pandemic and the lockdowns.

  • The recession, instead of being helped by the market system through the adjustment of prices (prices falling, wages falling,  to woo consumers back and firms to hire more workers), actually is caused by a human crisis:  a loss in economic confidence. 

  • If banks are failing and firms are going bankrupt, even if prices and wages fall, will you expand your business, and invest – of course not. If you lost your job, will you buy a car, even if car prices fall?  If your debtors are defaulting, will you as a bank, continue to lend money?

  • Keynes called this loss of confidence of investors/ consumers/ banks in the system a loss of ‘animal spirit’.  Wrong choice of words from my point of view, since it invokes some sort of voodoo. 

Government intervention and fiscal stimulus

• There is a downward spiral to hell during a recession: confidence shattered,  firms don’t invest, consumers don’t buy,  banks will not lend, businesses starting to fail for lack of demand and credit,  layoffs,  layoffs lead to less consumption, more businesses go bankrupt and layoff,  banks suffer because businesses default and financial crisis happen, more layoffs, more bankruptcy, dwindling consumer markets as more become unemployed, etc, etc – a downward spiral to hell.  No self-adjusting market mechanism

• Increasing money supply and reducing interest rate may not be sufficient if jobs and confidence do not return.

• So Keynes said government should intervene to stop the bleeding and recession and to get the confidence back.  The most effective will be fiscal stimulus.  Government should spend, undertake good projects and build beneficial infrastructure, using the mass of unemployed brought about by the recession 

• The projects and massive employment will have multiplier effects as the large numbers of unemployed will start to spend.  This will help businesses, workers and creditor banks get out of the quicksand they are in.

• Keynes, as we said earlier, did not believe that increasing money or credit and reducing interest rates will cure recession because it will not bring confidence back.  He called this the liquidity trap. Liquidity in economics means, close to money – money itself is a liquid asset, your atm/ savings deposits are also seen as liquid assets, because it can be very easily converted to money.

• One issue is the fiscal deficit.  Fiscal stimulus requires a lot of government spending and will lead to large fiscal deficits to save the economy.  This has been a perennial controversy among economists.  Keynesians usually argue the economic recovery due to the fiscal stimulus will increase incomes and gdp and will increase tax revenues to cover the initial fiscal deficits once economic recovery occurs.

• More conservative economists however fear that fiscal deficits might go out of control and lead to either debt default or credit rating downgrade of the country.  This is precisely the predicament the Philippines faces during and after the covid.  

Keynesian policies worked moderately during the great depression but more so after WWII

• Keynes put his ideas in a few books, the most famous being The General Theory of Employment, Interest and Money.

• President Franklin Roosevelt believed in Keynes’ recommendations and implemented the New Deal economic recovery program in the US in 1936.  The program had some initial moderate success but was complicated and finally interrupted with an impending WWII, which exploded in September 1939.

• After the war, Keynesian economics reigned supreme and was thought to be the theory that produced a long-term high growth in developed and developing economies in the second half of the 1940s and throughout the 1950s and 1960s.

The monetarist /new classical macroeconomic (NCM) school’s backlash vs Keynesians

• Let us make a diversion to a war story.  In 1973-1974, there was a Middle East War between Israel and its Arab neighbor.  Israel had already won two wars before – in 1948 and in 1967 (when they got the land from Jordan, which is now Palestine).  You all know that the former Israel of the Bible was conquered by the Muslims during the period of the Crusades.  So when the UN gave Israel back the land in 1948, the Arabs who had been in that land for several centuries therefore went into a war with Israel

• This time in 1973-74 everybody was surprised that Israel was losing the war in the beginning, especially to Egypt (under Anwar Sadat), which used Russian-built Surface to Air Missiles (SAM) to destroy Israel’s main strength – the war planes.  The US and Europe confronted Russia and a Third World War could have been triggered, and/ or Israel would have used its nuclear bomb (given to them by the Americans).

• In this confrontation Russia blinked to avoid a catastrophic nuclear war,  and stopped delivering SAMs to the Arab countries.  

The oil embargo and first-time oil prices skyrocketed

• The Arab countries got so angry at the US and Europe, they imposed an oil embargo globally (OPEC was born).  Oil prices shot up when there were no energy savers and no alternative energy then.  The inflation it brought in 1974 and beyond was high. 

• Then Iran overthrew the pro-US Shah of Iran and set up an Islamic State in 1979, and took all members of the American embassy as hostage.  (Watch the movie Argo directed by Ben Affleck).

• Another round of oil price increase brought inflation to double-digit in almost all countries including the developed countries.

• The inflation lasted very long – up to the 1980s.

• The conservative economists (the monetarists and new classical macroeconomists) – also called the Washington Consensus and neoliberals (these two latter are more political terms termed by the left) blamed the Keynesians who they claim spend and spend money and perpetuate inflation.  So they demanded Keynesians to reduce both fiscal and monetary spending and increase interest rates to reduce credit and money supply.  They also told developing countries to be frugal, don’t overspend and overborrow, even if they were very poor.

The Monetarists and new classical macroeconomists

• These new conservatives believe in the following:

  • The markets are very efficient and work very fast.

  • Intervening with the markets will change adversely the market signals and lead to unnecessary fluctuations (business cycles)

  • The private sector is more efficient and honest than the government sector

  • Fiscal spending is offset by the public knowing that they have to pay for the government’s spending by taxes.  They will offset government spending with consumption cuts and increased savings

  • People are smart.  They know spending will lead to higher inflation and so will expect higher inflation with higher government spending.  Again the government spending will be offset by household cutting their spending.   

The backlash against Keynesians 

• Conservatives won in the governments of key countries – Ronald Reagan in the US, Margaret Thatcher in UK and Helmut Shmidt in Germany – all adopted the conservative monetarist/ NCM school of thought.

• They reduced all fiscal spending, reduced money supply and increased interest rates to high heavens.

• This led to the 3rd biggest recession in modern history.  (The first the Great Depression 1929-1939, the 2nd the Great Financial Crisis (GFC, 2008-2009, the 3rd recession 1979-1983; (We still have to see if this pandemic and current recessions will beat one or more of the three).

• The critics of the monetarists and allies believe they had to cause a very deep recession  to effect a fall of inflation all over the world. (Recessions reduce the demand of people massively, and prices go down.) This happened in the first half of the 1980s. They declared victory and all three extended their terms (Reagan was lucky, the economic recovery came exactly on election year).

Dissatisfaction with the Monetarists / ncm (the 1990s and beyond)

• The conservative prescriptions of the brought about much suffering in the developing economies especially in Africa, LA and Eastern Europe, as the IMF became a very strict believer.

• The IMF implemented in earnest the prescriptions of the Washington Consensus to the Latin American/ Philippine economies during the Latin American debt crisis of 1981-1991. These economies fell significantly, and poverty increased.

• The Washington institutions (IMF and World Bank) were the architects of the shock-treatment in the return to capitalism of the erstwhile Soviet Union states–simultaneous and instant privatization and deregulation of state enterprises, instant return to market prices, from state-determined pricing.  Unlike the gradual, institutional changes in China, these states suffered deep economic collapse for almost a decade.

Dissatisfaction with the Conservatives(the 1990s and beyond)

• The standard prescriptions for economies running to the IMF for financial help during financial crises are:

  • Lower fiscal and current account (trade) deficits leading to cutbacks in government spending (and cuts in social and economic services)

  • Devaluation

  • Increase interest rates to fight inflation and to address devaluation

  • Open up the capital account (foreign money going in and out of the economy). During bad times of course this will lead to massive outflows of foreign exchange leading to more devaluation and loss of $$$ for required imports (like oil and gasoline).

Dissatisfaction with Monetarists and conservatives (the 1990s and beyond)

• The IMF implemented similar approaches to the East Asian (miracle) economies – Thailand, South Korea, Indonesia – during the Asian Financial Crisis (AFC), and aggravated the economic and financial collapse of these countries in 1997.  Many Nobel Laureates criticized the IMF when they implemented these draconian policies to the East Asian Miracles, which were very prudent in their fiscal spending. These failed experiments with the Wash Consensus prescription simply put this belief into disrepute. The IMF was forced to do a mea culpa decades later for their role in AFC

• A return to Keynesian economics, and debt workouts (agreements with the creditors to restructure the debts on easier terms), actually saved East Asia from collapse during the AFC, and saved the world from economic collapse from the Global Financial Crisis (during 2008-9).

• The East Asian Miracle countries obviously deviated from the Washington Consensus and became successful because of more interventionist strategies (e.g. state support for chaebols in Korea, state support for input suppliers of MNCs in Taiwan, Japan’s Ministry of Trade and Industry and sending scholars abroad to learn Western technology.)  We called this industrial policy in an earlier class.

Market Failures as the Central Criticism of Market Fundamentalism

• Coordination failures and multiple equilibrium: Having the right infrastructure, legal institutions and laws, market base and linkages, social and human capital are key to whether productive and high value-added firms and industries will enter the markets. This will require state interventions. (Example what are needed for Cherry Mobile and MyPhone to beat I-Phone and Samsung? Do we want this?) 

•  Positive externalities: Industries and firms that have positive beneficial and multiplier effects on all other industries should either be de-monopolized (forced to deliver if they are acting like monopolies), subsidized or assisted (if they are trying but struggling) or given the proper infrastructure and social/ political support: E.g., wifi, e-jeeps, shipbuilding (roro), backward linkages in the semi-conductor/ electronic products, etc. – includes addressing the first mover problem we mentioned in a previous lecture.  Again, some call this industrial policy.

Economies of scale and increasing returns to scale

• Increasing or economic returns to scale rather than diminishing marginal product was emphasized (Paul Romer, Robert Lucas, others – pls find). This means need for gov’t help in S&T and increasing productivity as demand grows

• These theories supported what the East Asian Miracles countries experiences

• IMF (2019) and Rodrik (2018) showed that East Asian Miracles happened because of strong government support and interventions towards technical and skills upgrades in all economic sectors. (The IMF has retracted their earlier conservatism)

Market Failures as the Central Criticism of Market Fundamentalism

• Firms with negative externalities should be punished, regulated and forced to stop (or reduce production): mining that depletes natural resources, destroys environment or ancestral domain; pollution-producing vehicles and factories, cyber-bullying, etc. 

• ‘Entrepreneurs’, positive risk-takers (innovators, inventors), ‘creative class’ should be given incentives and protected. First mover problem.

• Sectors providing multiplier, positive effects on other industries and the economy should be promoted (positive externalities)

Market Failures as the Central Criticism against Market Fundamentalism (the conservatives)

• Better education, skills and knowledge among the workers and firms may have ‘increasing returns to scale’ (similar to economies of scale)– may increase productivity several folds in a dynamic, vibrant economy. (Coming up with a ‘knowledge’ economy).

• Building a stronger social capital (trust and confidence) in the society and economy will also facilitate dynamic and sustained growth and healthy development of the economic sectors and the labor sector

• Agglomeration (clustering) economics: Strategy in growth areas, ensuring inter-firm connections: input-suppliers →→ product producers, economies of scale, high caliber infra and social services

• In China export processing zones, planned areas with quality infrastructure and technology, helped in the successful attraction of top-notch foreign investors

• All these do not spring from just the markets, but are either planned or are market failures (positive externalities, coordination failures, asymmetric information) – ie. They require state interventions, state direction, state coordination and state partnering with the private sector.

The heterodox economists

• These economists who adopt market failures and political economy arguments in improving institutions and governance towards economic development and higher economic growth had been called heterodox economists (they usually are also believers in Keynesian economics).  The most famous among them are Dani Rodrik, Joseph Stiglitz and Paul Krugman.  The latter two are Nobel Laureates, the first one is a strong contender in the future.