Question

Now that you have an understanding of monetary and fiscal policy, in your own words explain why you would agree or disagree with the following statement:

The government should not interfere if the economy is going into a recession; monetary and fiscal policy only create larger governments.

You must show in your answer that you have read the chapters and speak specifically to the issues that arise per the Author on trade offs when using both policies as well as the issue with lags and crowding out.

Answer 1

Recessions spread. A minor downturn in one business spreads to its suppliers and then to their suppliers. Workers are laid off (or simply fear that they will be) and buy less, spreading the downturn to other sectors of the economy. Since the 1940s, governments have tried to act to limit the damage caused by recessions, but not everyone agrees that government action can help.

Not everyone agrees that government action is appropriate when a recession threatens. These skeptics are rather more common among the net-savvy crowd than they are in the halls of government, but it's a position that has advocates even there.

There are two threads to the contrary view.

Government-caused

Even within the mainstream view, there's agreement that recessions are often caused by government action. Ordinary policy actions have some effect on the economy--and actions taken to "fine-tune" the economy especially so. Tax increases, budget cuts, and regulatory actions tend to suppress business activity. (Tax cuts and additional spending--especially deficit spending--tend to increase business activity, but even that can cause problems, as I'll discuss in the next section.) Even ostensibly neutral actions can shift money around in the economy, boosting one sector while suppressing another, and it's impossible to know whether on balance the result will make a recession more likely.

Of course, the main way the government causes recessions is by raising interest rates. The central bank does this to head off inflation (caused by the central bank actions that lowered interest rates earlier). This cycle is often compared to driving a car by alternately stomping on the accelerator and then the brake.

While everybody agrees that policy actions have effects on the economy, the mainstream view is that this means we should carefully consider policy actions and try to balance the effects in ways that minimize the harm--and if actual results in the economy show that things have gone awry, the government should take further action to try to "fix" the problem.

The contrary view is that the government action is the problem, and that there's no way that more of the problem is going to make things better. (People like to compare it to having a drink to treat a hangover.) The policy recommendations that come from this perspective tend to support low taxes, low spending, less regulation--basically, less government altogether.

Malinvestment

The other thread is a bit more technical. The theory is that in any business expansion, there will be people who make unwise investments. There will always be people who are too optimistic, too confident in their own forecasts, or who simply misread shifts in people's tastes.

If there's only a little malinvestment, it can be cleaned up by the people who made it. The swimming-pool installer who bought a new backhoe, figuring that global warming would mean that his business could only go up, may find that the housing downturn has made it tough for many of his customers to get the home equity loan they need to pay for a new pool. If nothing else goes wrong, he can probably work his way out of the problem--lower profits while he pays off the under-used backhoe, but not a business failure.

Inflation always causes malinvestment, because inflation fools people into thinking that things are going especially well. Businesses see a surge in businesses, which prompts them to expand. When it turns out that the surge was all illusion (they were getting more dollars, but the dollars were worth less), they've already committed to an expansion that has no future.

Government spending produces malinvestment a well, as businesses gear up to produce whatever the government is buying today. It's obviously not the best use for the investment (or you wouldn't need government spending to support it), plus it's highly vulnerable to being a very bad investment, if government priorities change.

When there's a lot of malinvestment, though, is not so easy to fix. A company that has borrowed to expand, but doesn't get enough business to service the new debt, is in trouble. Even businesses that aren't in debt can shut in a downturn. If business gets bad enough, it's cheaper to just close the doors than to pay to keep the place staffed and the lights turned on.

As to whether governments can help in a recession, the answer clearly depends on where you stand. Cutting interest rates is great for people who have variable-rate debt (or would like to), but it sucks for people who have cash. Higher government spending is all well and good for people who build roads or grow corn, but doesn't mean much for the guy who runs a bakery or works at a video store (except, eventually, higher taxes).

In the end, the people who are helped are very specific and very aware of the help, while others are either not harmed, or are harmed only in a diffuse, general way (along with everyone else). The result is that the political pressure always tends to be on the side of more help. Whether it helps the economy or not, it definitely helps the people who get it, and that's enough for the politicians to keep at it.