Do we need a recession to purge the rottenness out of our system?

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The commenter formerly known as p_lukasiak (now charmingly rechristened mediasux), asks an excellent question:

Now, correct me if I’m wrong, but the whole purpose of the Fed was to act as a brake on the economy when inflation rears its ugly head. And while I was initially supportive of a stimulus package, the problems with the economy are structural — temporary stimulus can delay the recession, but it can’t prevent it.

The one thing I give Reagan credit for (sort of) is riding out the recession that occurred during his first couple of years in office — the economy was completely out of whack as a result of the oil embargo in the seventies from which it never recovered. Doesn’t it make more sense (at least economically) to ride this one out?

Actually, the Fed was conceived in the aftermath of the Panic of 1907, and its purpose was to put someone other than J.P. Morgan in charge of halting financial crises before they turned into depressions. It failed pretty miserably at that in the early 1930s, and I think one of the things Bernanke is doing now is trying to avoid repeating those mistakes in a financial crisis that is similar in form if not in gravity to that which unleashed the Great Depression. Stuff like the discount rate cuts and the Term Auction Facility are meant to grease the wheels of the financial system and keep it from freezing up. Cutting interest rates helps, too, simply because an interest rate cut immediately boosts the financial position of banks.

As for cutting rates and squirting money around to stimulate the overall economy, as opposed to letting the recession take its “natural” course, there’s some serious disagreement. Andrew Mellon’s belief in the early 1930s that a depression would “purge the rottenness out of the system” hasn’t held up very well. Writes Brad DeLong:

Milton Friedman likes–alas! liked–to quote R.G. Hawtrey of the British Treasury, who said that Mellon and the others who thought in 1930-1933 that the big danger was excessive inflation were “crying ‘Fire! Fire!’ in Noah’s Flood.”

Mainstream American economists simply don’t buy the argument that economic downturns have some sort of redemptive and cleansing effect. Here’s Paul Krugman, writing almost a decade ago about what he called the “hangover theory”:

The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can’t stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory’s seductive charms—especially when it gives them a chance to lecture others on their failings.

Funny thing is, the theory also continues to appeal to perfectly serious (and non-Austrian) economists across the Atlantic. Here’s “Maverecon” Willem Buiter of the London School of Economics, writing just a few days ago:

A significant slowdown in the US, perhaps even a recession, is necessary to restore a sustainable desirable level of the national saving rate. There can be further beneficial longer-run effects from a recession, because recessions are quite efficient mechanisms for purging, through defaults, insolvences and financial and real restructuring, the distortions, inefficiencies and misallocation of resources that were created by the financial excesses in the US economy during these past five years. When it has to happen, why wait?

Or Gilles Saint-Paul of the University of Toulouse (home of possibly the top economics department in continental Europe):

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

I guess these Europeans could simply be leaping at the opportunity to lecture us profligate Americans on our failings. Or maybe it’s not as open-and-shut a case as DeLong and Krugman would have us believe.

Update: A reader who was taken aback at being told he was “not authorized to comment” (this new version of Movable Type is tough) e-mails:

I believe we’re going to have problems with the housing market for quite awhile that a recession will do absolutely nothing to fix. Mainly, that most home buyers are not sophisticated investors, that is, while they understand in theory the concept of risk, the practical aspects of it do not actually register for them.

When the stock market drops, institutional and professional investors make (mostly) rational decisions about what losses to take, what losses to hold, and where they can pick up a profit. This is partly due to the fact that they are not using their own money and can thus be more objective about the situation. Home owners, who are largely unsophisticated, unprofessional investors, bought into a bubble stock (houses) thinking it was a conservative, safe investment. They are incredibly tied up, both emotionally and financially in this investment. Now imagine that you just bought a house for $200,000. You make $45,000 a year. The house was appraised at $205,000 before you bought it. Now, with your ARM rising and needing to sell, you can’t find a taker for more than $150,000. You remember always hearing that housing always goes up and a home is the best investment you can possibly make. You are not versed in the financial world’s various archaity’s. You only know that your house was worth $205,000 two years ago and you expect to make a profit on selling it.

This is what I believe is really killing the economy, too much money is tied up in bad (overvalued) investments and it has started to hurt consumer spending as guys like the one above fight to make their rising mortgage payments until they can unload the property at what they view as fair value. Most of these people aren’t conditioned or willing to adjust downward and take the loss. So it’s entirely possible the economy may stay in the doldrums until housing prices actually catch up to what they were perceived to be two years ago. And with a slowing economy, housing prices will rise slower than otherwise, thus prolonging the cycle. This is a systemic problem that won’t be addressed by a simple government stimulus package or tax cuts. I’m not smart enough to formulate a workable answer to this problem if I am right about what’s wrong with the economy, but it would be nice to see people that are start working on the correct problem. (If I am indeed correct, of course.)