A necessary evil
A necessary evil
Should we learn to love recessions?
When america’s bubble burst in 2001, the Fed swiftly cut interest
rates. This has become a habit: every time there has been any
financial turmoil at home or abroad – such as the crises in East Asia and
Russia and the near-collapse of Long-Term Capital Management in 1998
– the Fed has pumped more money into the economy. Low interest rates
saved America from a deep recession. But after such a binge, might the
economy not benefit from a cold shower?
Most people would consider this a heretical question. They assume
that it is a central bank’s job to avoid recessions at all cost. According to
one survey, four-fifths of Americans believe that preventing recessions
is as important as preventing drug abuse. But are recessions always an
unmitigated disaster, or do they also offer some economic benefits? And
if central banks respond to every danger sign by pumping in more
money, does this not risk simply transferring the problem elsewhere? As
America’s stockmarket bubble has burst, another bubble now seems to
be inflating in its housing market. This allows consumers to go on partying,
but what happens when the drink runs out?
According to the Austrian economic paradigm, recessions are a natural
feature of an economy. Joseph Schumpeter argued that recessions
are not an evil that should be avoided, but a necessary adjustment to
change. Only by allowing the “winds of creative destruction” to blow
freely could capital be released from dying firms to new sectors of the
economy, thereby boosting future productivity.
Hayek counselled against massive monetary easing to prevent a
recession. If unprofitable investments were made during a boom, then it
was better to shut those firms down and clear the way for new, more
productive investment. For the Austrian economists the policy choice is
not between recession or no recession, but between one now or an even
nastier one later. A recession is necessary to work off an imbalance
between too much investment and too little saving.
Keynes, quite reasonably, ridiculed the idea that in the long run the
Great Depression might turn out to have been a good thing. In the
early 1930s the Fed and the American Treasury did not pursue expansionary
policies, precisely because they thought these might hinder the
THE PHONEY RECOVERY
necessary adjustment. Andrew Mellon, the secretary of the Treasury,
urged the market to “liquidate labour, liquidate stocks, liquidate the
farmers, and liquidate real estate … It will purge the rottenness out of the
system.” America’s output duly fell by 30% as the Fed sat on its hands.
Today, a slump on that scale would be unlikely even if the Fed had
not cut interest rates swiftly. It would have been headed off by a variety
of changes made since the Great Depression: higher government
spending and hence more powerful automatic fiscal stabilisers; bank
deposit insurance; and a stronger commitment by the Fed to its role of
lender of last resort. But even the Austrian economists themselves came
to reject the idea that faced with a potentially severe recession, policymakers
should do nothing. They approved of stimulus measures to stop
recessions from turning into deep depressions, but not of preventing
The case for the defence
Why is economic instability always assumed to be bad? Some
economists argue that recessions result in a permanent loss of output.
This rests on the notion that there is a fixed ceiling for output, rising over