Recent Economy

The Causes of Recessions

What causes recessions? The answer is both complex and simple. It is complex because there is always an element of what John Maynard Keynes referred to as “animal spirits” driving recessions, such as confidence, uncertainty, and pessimism. These animal spirits do not accommodate themselves to objective, quantitative analysis.

But if events of the animal spirit variety are acknowledged, but then set aside, explaining recessions ex-post becomes relatively easy. The primary culprits then boil down to errors in monetary and fiscal policy that destabilize aggregate demand, a variety of shocks to the productive capacity of the economy that are relatively quantifiable, and spillover effects from financial crises (International Monetary Fund, 2001, 68-71).

Policy Errors

In a sense, most recessions could have been avoided. After the fact, one can identify alternative monetary and fiscal policy choices that, if employed, would have prevented - or at least alleviated - most recessions. Most recessions are caused by declines in aggregate demand - individuals and firms no longer desire to purchase as much as the economy can produce. If prices adjusted quickly, the price of goods and services would fall to the point where aggregate demand would purchase what the economy could produce and recession could be averted. Since prices do not adjust quickly, output must fall in response to the fall in demand (Tully, 2008, 45-48).

Although sticky prices make instantaneous market adjustment impossible, it does enable fiscal and monetary policy to manipulate aggregate demand to boost real purchasing power when the economy is in a recession. Because fiscal and monetary policy have wide latitude to manipulate aggregate demand, one can theoretically envision that there would always be a policy stance consistent with a fully-employed economy (Sloan, 32-35). Theoretically, any change in the behavior of private actors, positive or negative, that affected aggregate demand could be completely offset by fiscal and monetary policy, allowing for smooth and continuous economic growth.

Unfortunately, information is limited and the effects of policy changes are often slow, variable, and uncertain. Thus, in hindsight, “erroneous” policy decisions can be identified that moved the economy away from full employment or prevented the economy from quickly returning to full employment. Policymakers at the time may have made the best decision based on the information available to them, but with the knowledge one has after the fact, one can identify alternative policy decisions that would have prevented or alleviated the recession. Such policy errors come in two common varieties (Witte, 36-39).

First, there are frequently policy errors that lead to the economy growing at an unsustainable pace. To prevent accelerating inflation and other economic imbalances from widening, these errors must then be reversed, and in the process of reversal the economy often “overshoots” and enters a recession. This is why the boom and bust pattern of business cycles is so typical, and why “hard landings” tend to be the norm and “soft landings” the exception (Makinen, 23-26).

Second, there are policy errors that occur because policymakers react to the onset of a ...