The Great Recession of 2008 – The Policy Debate Over the Effectiveness of Fiscal Policy and Monetary Policy to Combat the Recession
The financial and economic crisis that began in 2007-2008 has been named the Great Recession by the public due to its negative impact on the national and global economies. However, there is no consensus among economists on the effectiveness of fiscal and monetary policies that were implemented during the global crisis. This issue is of particular importance because of the current post-crisis instability in the markets worldwide.
The general agreement among the Keynesian economists was that stimulating aggregate demand was the proper objective at the outbreak of the global recession. According to their view, the government policy strategy should include an automatic and a discretionally fiscal component. As usual, government spending tends to increase automatically during recessions due to the increase of unemployment insurance, welfare payments, and other transfers. On the contrary, government tax revenues tend to decrease with the corresponding fall of economic activity. These factors result in creating the countercyclical budget deficit. However, some additional discretional measures may be implemented to stimulate the economy. These measures commonly include the cuts of tax rates for businesses and households as well as direct financing to entrepreneurs and firms in the form of contracts, government loans or grants for the purposes of new investment and additional market demand (Tcherneva, 2011, p.5).
The U.S. policy response to the financial and economic crisis followed this general Keynesian recipe. Moreover, government policy included even some additional expenditure that is not typically considered as a countercyclical measure. The first major part of government spending was executed by the Federal Reserve System through the purchases of a large number of different financial assets of selected banks. These measures constitute a fiscal (and not a monetary) policy because they were executed by the Federal Reserve System with necessary congressional authority. It may be concluded that in fact it was the Treasury that bought different financial assets from selected banks. The first Trouble Asset Relief Program (TARP) was introduced at that time. The TARP enabled a large injection of funds into some market giants (such as GM, Citigroup, etc.) and the subsequent de facto nationalization of the insurance company AIG.
The second stage of the government fiscal plan was American Recovery and Reinvestment Act (ARRA) that was introduced in February 2009. At the same time, the White House began to realize the longest unemployment program in American history. The total budgets for TARP and ARRA constituted almost 10 percent of the U.S. GDP. In spite of all these measures, their effects on economic growth and general employment were not large (Baker, 2009). It happened because of a few reasons. First of all, despite government increased its spending, companies and households continued to decrease their spending due to significant market uncertainty. Thus, they counterbalanced to some degree government measures. Secondly, tax cuts were not necessarily used by the firms for the purposes of investment. Even when the government measures were able to increase the gross output and production, they did not produce employment creation effect of a necessary scale. That happened due to the restructuring that took place during the global recession. Firms typically tried to optimize their cost structure by reducing labor costs.
The labor force participation rate declined constantly at that time, and it was the longest decline in post World War II history. The employment population rate collapsed to unprecedented level of 58 % (Tcherneva, 2011, p.6). There was also massive destruction of full-time and part-time jobs as well as the level of long-term unemployment rate.
Traditional Keynesian analysis, instead of targeting a job creation, tries to target economic growth that should increase employment. Moreover, as fiscal policy is commonly upside down, the government measures have permanently failed in achieving something close to the full employment level in the economy. That is why the very concept of “full employment” has been replaced by the “natural unemployment rate” advocated by Milton Friedman. It seems that creating jobs directly may be considered as the only suitable method for reaching long-run economic stability and generating full employment.
Government analysts dealt with the actual components of GDP and argued that since investment and consumption declined during the global recession, the government expenditures were able to counterbalance them. It was because the government sector was considered as the only one that was able to discretionally change its level of spending. The government objective was to return the U.S. economy to the selected growth path according to Okun’s Law. However, there was a debate about the most appropriate method that could be used in order to stimulate the economy. Keynesian economists who saw the recession as a direct consequence of the fundamental mechanism of the market process that endogenously produced unstable aggregate demand preferred a policy response that stimulated market demand through government spending. Economists who saw the recession as a consequence of some exogenous or external shocks preferred to work on the supplied side and advocated the policy that influenced market incentives that were expected to stimulate investment and consumption. This kind of measures included a reduction in wages, cuts in marginal tax rates, direct subsidies to firms, etc. In both cases, however, it was assumed that investment and consumption would recover, either as a result of the direct government intervention or to a large number of incentives that reduced costs or increased after-tax incomes. Often both kinds of policies were adopted such as direct government expenditures and simultaneous cuts in tax rates.
However, when Keynes (1936) discussed the problem of unemployment in the economy, he considered it as a problem of inadequate effective market demand, not inadequate aggregate demand. In general, employment is always a function of the entrepreneurial judgments about the expected future earnings that can influence a company’s decision to hire a number of people. Thus, employment depends on the fraction of income households prefer to hoard and the manner they use to save.
As for the monetary policy during the Great Recession, the goal was to stabilize the economic situation after a significant shock to aggregate market demand by providing a counterbalancing positive impulse to demand with the methods that were available for policymakers. The main method of the Federal Reserve System was control over short-term interest rates.
The Federal Reserve System began decreasing short-term interest rates in August 2007 and introduced support to some financial institutions at the beginning of 2008. Interest rates were set at less than 1 % by October 2008 (Tcherneva, 2011). The Federal Reserve System also found other means to provide support through the economy. It began to provide additional support for illiquid financial institutions through so-called “alphabet soup” or its main lending programs. This kind of programs allowed reducing existing credit spreads on the national debt and stabilizing the entire market situation of the late 2008. Then, the Federal Reserve System implemented two rounds of “quantitative easing” in order to decrease long-term interest rates using the purchase of long-term market assets. The first round of quantitative easing (including operations with Fannie Mae and Freddie Mac) showed good results established the fact that the Federal Reserve System was able to decrease the long-term interest rates.
The next round of quantitative easing was introduced in November 2010. It was focused primarily on the debt of the American government. As a result of market anticipation of these measures, interest rates decreased not only regarding the U.S. debt but other market rates as well.
It is generally considered that the Great Recession would have been even worse in case the Federal Reserve System kept interest rates at the level of 2007 that was 5.26 % (Bivens, 2011). However, the Federal Reserve policy of low interest rates created some additional problems for the U.S. economy.
- Low interest rates did not enable the entrepreneurs to direct resources to the most productive use as the price system was disturbed.
- This kind of policy made it easier for firms to avoid necessary reallocation of their assets.
- It increased the level of uncertainty as the market participants had to take into account not only different economic factors but the Federal Reserve policy as well.
Hummel (2011) considered the Federal Reserve System under Bernanke as a type of central agency because of the Federal Reserve’s intervention in the monetary sphere (p. 512). He suggested that the Federal Reserve’s planning will finally “prove an unfortunate failure”. In fact, the policy advocated by Ben Bernanke was very much different from the monetary theory of Milton Friedman though he often claimed the adherence to Friedman’s position. For instance, Anna Schwartz, Milton Friedman’s coauthor on monetary history of the United States, criticized Bernanke for his policy of lowering interest rates to zero (Bullock, 2009).
In general, it may be concluded that fiscal and monetary policies during the Great Recession had both some positive and negative consequences. First of all, they allowed stopping the market panic at the first stage of the crisis that was very important for the support of the financial system. At the same time, the unprecedented government spending and the policy of low interest rates implemented under Bernanke created the significant problems for the stability of the U.S. economy in the long run.