Economics For Dummies, 2nd Edition

Economics For Dummies® Covers the Origins and Aftermath of Financial Crises

ADAPTED EXCERPT FROM CHAPTER 17

Why does the recovery from post-bubble recessions tend to take so long and why do government policies that can work well against normal recessions have trouble speeding up the recovery process after an asset-price bubble collapses?

The U.S. housing bubble of 2000–2006 was the largest real estate bubble in world history. But even after the recession ended and the economy began to slowly grow again in the summer of 2009, unemployment remained very high and businesses were producing at levels far below their capacity. Some experts ascribed this to low aggregate demand caused by banks’ reducing lending and consumers’ reducing consumption in order to deleverage.

Other experts, however, feared that the U.S. economy was suffering from a structural mismatch. Their reasoning was that during the bubble, firms had used their access to easy credit to build up lots of capacity to produce things that were popular during the boom — large new houses, fancy malls, and plenty of SUVs and large trucks. After the bubble popped, however, consumers didn’t want lots of new houses or new SUVs or additional large trucks. Instead, they wanted products such as iPads, better touch-screen cell phones, and smaller cars, as well as the ability to do more of their shopping over the Internet instead of driving to shopping malls.

If that interpretation is correct, then recovering from the 2007–2009 recession will be a much slower process than recovering from a plain-vanilla cyclical recession. The added difficulty comes from having to re-jigger the economy’s production capacity from making the products that were in demand while the bubble was expanding to producing the different goods and services in demand after the bubble bursts.

Making that transition requires revamping old firms or starting new firms; having to move workers away from dying industries into new industries; and undertaking the time and expense of retooling factories and restructuring supply chains. Making those sorts of adjustments all over the economy is not a quick process.

Unfortunately, government stimulus policies often appear unable to significantly speed up the recovery process after a financial crisis. The policies are stymied by the debt that remains after the bubble pops.

Post-bubble consumers want to deleverage, or get rid of their debt. Here’s how the desire to deleverage hampers both fiscal and monetary policy:

*  Fiscal policy: Post-crisis fiscal policy comes in the form of massive increases in government spending that are intended to stimulate aggregate demand by having the government purchase lots of goods and services. But in the aftermath of a debt-driving bubble, fiscal policy’s stimulatory effects may be limited because people often use increases in income to pay down debt (instead of using the money to purchase additional goods and services).

*  Monetary policy: The government attempts to use monetary policy to stimulate demand by lowering interest rates to encourage both consumers and firms to borrow and spend more. However, monetary policy fails to work very well after a debt-driven bubble because highly leveraged consumers are in no mood to borrow more money. They’re understandably more interested in paying down their current debts than in taking on additional debts.

If this situation sounds very dismal, it is. Until the debt level in the economy falls so that people do not need to devote so much of their incomes to paying off loans, economic growth is likely to remain stagnant, and government attempts at monetary and fiscal are likely to prove ineffective.