What is the role of government during recessionary times and what can we learn from past recessions? Liesel Beires Research and Development Unit Beiresl@kznded.gov.za 0825208753 1 Introduction The recent recessive economic climate has brought to the fore the debate around what role governments should play in the economy. Economic history shows us that during recessive economic conditions governments have always implemented either monetary or fiscal measures to kick start economies. This current recession has proven to be no different with countries having already committed $2, 75 trillion in fiscal stimulus, with the US and China being the biggest fiscal spenders thus far. The intention of this paper is to give a brief synopsis of what fiscal and monetary policies are and how they differ in their implementations and effects during a recession. The paper will also address what is being done in South Africa both on the Monetary and Fiscal Policy front. The paper will also discuss the concepts of depression economics and the ideas presented in the theories regarding the Paradox of Thrift. Finally the paper will examine what lessons can be learnt from previous recessions and what policies were successful during these times. 1. The difference between Monetary and Fiscal Policy and their effects on the economy Monetary and Fiscal Policy can be classified as the two major policy frameworks through which the government exercises its power over economic conditions. From the foundations of economics as a science there has been vigorous debate regarding the government’s role in the economy. The mainstream or so called “classicalist” view point has been that government is there to provide a safe environment in which an economy can operate. It is also there to provide public goods, which are those goods for which there would be no incentive for private companies to provide, such as your utilities for example. According to the “classicalist” view the government should not get involved in the economic operations of the economy but should instead leave the “market” to outwork itself and so apportion economic activity amongst the role players in the economy. Another school of thought sees a more involved role for government, especially when it comes to apportioning economic activity and prosperity across all groups in society. With the onset of the recent global crisis there have been many that have cried that it signifies the end of free market thinking and the end of capitalist philosophy. However, much of the same scenario as we see today was played out during the 1930’s depression to an arguably even severer extent. Then and now the government has always only had two tools although different at their disposal to keep their economies under control, those of monetary and fiscal policies. 2 1.1 Monetary Policy Monetary Policy can be defined as a set of policies that a county’s central bank implements in an attempt to influence the supply of money and interest rates and thereby influence the level of economic activity and the amount of inflation in a country. The central premise on which Monetary Policy is based is that there is a link between monetary variables (such as the quantity of money and interest rates) and macroeconomic variables (such as price level, level of employment and GDP). This link is often referred to as the Monetary Transmission Mechanism and it is used to describe how changes in the monetary variables can effect change in the real economy. This link is fundamental to Monetary Policy as it is through this transmission mechanism that countries’ central reserve banks can try and produce changes in the real economy. Although this transmission mechanism is believed to exist within the economy, the ability and success of Monetary policy to effect factors such as unemployment and output levels has been debated. An example of how the Monetary Transmission mechanism works in South Africa can be seen in the following example. In South Africa the SARB (South African Reserve Bank) has set itself the goal of solely achieving price stability as its objective. This is clearly spelt out in the objectives of the SARB’s monetary policy which states that the aim of Monetary Policy in South Africa is to protect the buying power of the rand. The primary method which has been chosen to do so is inflation targeting which involves setting inflation targets (3-6%) and using interest rate changes to affect the level of spending and credit extension in the economy. This has been implemented to achieve two main purposes: 1. To prevent money itself from being a major source of economic disturbance 2. To provide a stable background for the economy In achieving these two purposes Dr XP Guma (Deputy Director of the SARB) believes that it enables producers and consumers, employers and employees to proceed with full confidence that one aspect of an otherwise unknowable future is predictable, that of the “purchasing power of money”. If economic players have peace of mind regarding the purchasing power of their money it allows entrepreneurs to plan and act and savers to save without fear of their investment being eroded by inflation. Inflation targeting has not always been the method that the SARB has chosen to achieve its goal of price stability. This regime was implemented in 2000 and has been in existence for nine years. The table below outlines the five “regimes” that have governed Monetary Policy in South Africa since the 1960’s. 3 Table1- Table showing the different Monetary Policy Regimes in South Africa YEARS REGIME DESCRIPTION 1960-1980 Liquid- Asset Based System Quantitative controls of interest rates & credit 1981-1985 Mixed System Banks held certain % of their liabilities in the form of cash reserves with the SARB. Cost of credit was linked to the SARB discount rate. 1986-1998 Cost of Cash Reserves system with Pre-announced targets of money supply monetary targeting pursued indirectly through changes in the SARB’s bank rate. 1998-1999 Repurchase Agreement System (REPO Repurchase system coupled with pre- system) announced targets of money supply & informal targets of core inflation. 2000-2009 REPO system with formal inflation Monetary Policy Committee meets regularly to targeting consider adjustments to the repo rate Source: Mohr et al 2004 This table above highlights that there are different ways in which the Monetary Transmission Mechanism can be implemented in the economy. The move towards using the Repo Rate method is in keeping with the emphasis nowadays on using market-oriented policy measures to guide financial institutions into taking certain actions. The way in which this works is that part of the role of the SARB is to be the “lender of last resort” in the economy. The repo rate is the rate at which the SARB grants assistance to the banking system and represents the cost of credit to the banking system. If the repo rate is changed it automatically implies that interest rates charged by banks on deposits and lending also change. It is through this process that the changes in interest rates reach the real economy. The diagram below captures the Monetary Transmission Mechanism quite effectively and shows how ultimately changes in the Repo rate affects aggregate demand in the economy, which in turn should keep inflation in check. 4 Diagram1- The Monetary Transmission Mechanism Source: M Sichei 2005- University of Pretoria The idea of the SARB only having one policy objective of inflation targeting rather than mixed objectives is not unique to South Africa. In recent years both politicians and economists have advocated that the stabilization of inflation be left to Monetary Policy. This is why many central banks around the world have chosen to focus only on achieving price stability in an economy. The rationale behind this is that it is believed that Monetary Policy that is aimed at price stability will take into account the state of cycles in the economy. This implies that when the economy is booming or on an upswing then inflation is likely to be slightly higher and therefore interest rates will be proactively raised in order to prevent inflation from drastically increasing due to an overheated economy. Likewise on the other side of the cycle if economic growth is slowing and recessive times are prevailing then inflation should theoretically be declining, which would give central banks room to reduce interest rates in an attempt to stimulate investment and economic activity. However to the critical eye, one would already see that presently in South Africa, this has proven not to be the case. We have seen our economy go into a period of slow growth; however it appears that inflation is proving to be stubborn in its rate of decline. This can be the result of two factors. The first one is that in economics one has the phenomenon of “sticky prices” which says that prices are quick to increase, but slow to decrease, which is proving to be the case. The second factor is that inflation can remain high in an economy despite a slow down in economic activity due to a supply shock occurring. An example of a supply shock would be the two things 5 that we have and are about to experience shortly in the South African economy. The first one would be an increase in oil prices and the second one being a drastic increase in energy prices. When a supply shock occurs it results in prices and output moving in opposite directions. In this instance the objective of solely achieving price stability becomes difficult for Monetary Policy. Brash (1993) indicates that in this circumstance Monetary Policy should in principle accommodate at least part of the adjustment, as to do otherwise would mean taking all the adjustment of the supply shock in the form of lost output. He states that in this case there is merit to allow inflation to lie slightly outside the inflation target band. The question remains, if the South African SARB would take a view such as this in this kind of circumstance? Judging on past behaviour, one has seen that the SARB has been very focused on keeping inflation in the 3-6% band. We have already seen a halting in the decreasing of interest rates as inflation is proving to be stubborn in its descent. With the imminent 34% increase in Eskom tariffs this is only likely to exacerbate this problem. However this could theoretically be viewed as a supply shock and therefore be accommodated for by the SARB. Dr XP Guma (Deputy Director of the SARB) asked the question in May 2009 of whether achieving price stability was enough. His answer was “Yes, in ordinary times, but No, in extraordinary times”. He went on to say that slave like adherence to an invariant policy stance is unlikely to yield optimal outcomes when circumstances change dramatically, as they have in recent times. Although this statement has been made, one could still question if the SARB has in fact adhered too much to inflation targeting, especially during these recessionary times? The debate around adherence to inflation targeting is not a new one, with recent statements made by Cosatu indicating that there is room for the SARB to introduce more interest rate cuts and revisit their policy of inflation targeting. In an article by political economist Mohau Pheko (2008) she states that we need to eradicate the myth that the goal of inflation targeting should be the end-all of monetary policy. This is especially the case if the focus on fighting inflation excludes other key development goals such as job creation and poverty eradication. She cites a study done by World Bank Economists Bruno & Easterly (1996) who conclude that there is growing evidence that moderate rates of inflation have no predictable negative consequences on the real economy. They also show that moderate inflation is not associated with slower growth, reduced investment or any other important real variables. In their study they liken the relationship between growth and inflation to a bickering couple, as these two variables cannot decide what their relationship should be. Their empirical study shows that in the short run there does appear to be a positive relationship between inflation and growth. Case studies from Latin America and Brazil show that countries were able to achieve high growth 6 rates and have double digit inflation rates. They found that this positive relationship between inflation and growth remained in tact for inflation rates between 15-30%, if inflation surpassed these figures, the relationship turned negative. They indicate that inflation rates between 15-30% can be classed as moderate inflation rates and are ones that can be sustained for long periods without causing a growth catastrophe. They also found that supply shocks are the predominant factor in high inflation crises and that these episodes of high inflation (defined as inflation rates of over 40% for a period of 2 years or more) are discrete events rather than the norm. The study done by Bruno & Easterly (1996) has significant findings and does lead one to question the significant importance that has been placed on inflation targeting in recent years. Even if one chooses to target inflation one can question if a 3-6% inflation target band is too prudent and if there is in fact scope to adopt a slightly higher band. Pheko (2008) asks why does it have to be 36% and why can’t it be 8-15%? From the Bruno & Easterly (1996) study this band could even be higher. Joseph Stiglitz former head of the World Bank has become synonymous with the fight against inflation targeting and has on many occasions called for its abandonment. In one of his papers, Stiglitz makes a case that in developing countries an inflation rate of 10% and over is often necessary to stimulate demand and economic growth. In one of his recent talks in South Africa, Stiglitz actually laid some of the blame of the current financial crisis at the feet of central banks that have been focusing excessively on inflation. He also dismissed the notion outright that inflation targeting is necessary for strong and stable growth. Like Bruno & Easterly’s (1996) study Stiglitz indicates that inflation in developing countries is largely as a result of supply shocks, such as increases in oil and food prices. Stiglitz argues that in these cases if one uses interest rates to try and reduce aggregate demand and in this way tame price increases in goods and services; one will have to take interest rates to intolerable levels to bring inflation down to targeted levels. In this circumstance inflation targeting has little effect on keeping inflation in check. This is why Stiglitz has called for the abandonment of inflation targeting especially in developing countries. Stiglitz states that many countries have already moved towards a more flexible inflation targeting system and that containing inflation has to be balanced with other concerns such as sustaining growth. It appears that South Africa has not had this shift in mindset yet. Perhaps there is a tendency to have a slave like adherence to inflation targeting in this country rather than seeking to implement Monetary Policy that has an element of accommodation for the current downturn that the country is facing. The other side to this argument is that during recessionary times when investor confidence and expectations are at an all time low, Monetary Policy may actually have very little effect on the 7 economy. This is especially the case when a recession has been brought about by a crisis in financial institutions. This is because when credit markets cease to operate efficiently the channels (or monetary transmission mechanism) through which conventional Monetary Policy operates ceases to be effective. This phenomenon was labeled a “liquidity trap” by the famous economist John Maynard Keynes. A liquidity trap results when people are scared of debt and will not borrow even if the cost of money falls virtually zero. This results in Monetary Policy becoming ineffective as consumers would rather hold onto their money rather than invest or borrow. This has further consequences for the “Paradox of Thrift” which will be discussed later on in the paper. It is because of this that some have argued that Monetary Policy is very effective in slowing down an overheated economy but it is not so effective in stimulating a lagging economy. This would especially be the case if the lag has been caused by a financial crisis. Although there may be merit to this argument one needs to bring into the equation the issue of sentiment and expectations. Economic behaviour is largely driven by prevailing sentiment or “animal spirits” as it has often been termed. These prevailing sentiments often turn into self fulfilling prophecies, as if people are expecting an economic downturn, they stop spending which reduces aggregate demand which in turn causes an economic downturn. In this regard Monetary Policy could have an important role to play as a signaling mechanism in the economy. Having lower interest rates or an environment where interest rates are being reduced does have an impact on improving general sentiment in the economy. Although there may be a lag in the time it takes for people to start investing and borrowing again, it is acting as a signal that the cost of capital and investing is decreasing. This will act as a signal that the economic climate may be more favourable to start spending money in again. Besides acting as a positive signal a decrease in interest rates also has an impact on those that already have debt as it decreases the cost of this debt for them and results in them having a bit more disposable income in hand to start spending in the economy. One can therefore not rule out Monetary Policy as a tool to be used effectively during recessionary times. 1.2 Fiscal Policy Fiscal Policy refers to the ability of government to spend directly in the economy in an attempt to stimulate aggregate demand in the economy. There are three main types of tools available to government under Fiscal Policy, these are: 1. Changing/cutting tax rates 2. Changing/increasing government spending 8 3. Automatic Fiscal Policy adjustments such as unemployment insurance During recessionary times, Fiscal Policy is often preferred as a stimulatory tool as it can be used to directly target the areas/groups in the economy that need the stimulation the most. Examples of such measures could be increases in means tested benefits for low income households; reductions in the rate of corporation tax for small medium enterprises or investment allowances for businesses in certain regions. Fiscal Policy has also proven to be more effective than Monetary Policy during recessions that have been caused by financial crises. This is due to the liquidity trap scenario that was discussed earlier where Monetary Policy can prove to be ineffective due to people’s lack of willingness to borrow. In this instance direct investment into the economy through government spending has a greater positive impact on aggregate demand. An IMF (2009) study showed that recessions that are associated with financial crises are typically severe and long lasting. They found that during these times Fiscal Policy is needed to try and help speed up the recovery period. Their study showed that over the past 50 years there have been 122 recessions globally, with the 15 recessions that were associated with financial crises being the longest and most costly. This is because during recessions that occur after financial fallouts households usually drastically change their savings behaviour in an attempt to restore their balance sheets. This in turn leads to a sharp decline in consumption. This is why policy makers argue for the need for Fiscal Policy to be implemented to prevent a severe decline in aggregate demand and the subsequent consequences from this such as unemployment and reduced output. There has however been much debate regarding the usefulness of Fiscal Policy, with the classical/free market thinkers not being a proponent thereof. This is because they largely base their arguments on the concept of “crowding out”. This idea is based on the premise that individuals’ change their own behaviour when government starts spending more in an economy. Therefore instead of increasing spending in an economy it merely changes the composition of spending to more public spending rather than private. This is based on the belief that people have rational expectations and when they see that government is spending more they factor in future tax increases and therefore increase their current savings in anticipation hereof. During the current recession it appears that governments have chosen to implement Fiscal Policy through embarking on some of the largest fiscal stimuli programmes yet as was seen in the opening introduction of this paper. The buy-in into the fiscal stimuli ideology has been neatly summed up in Barack Obama’s quote of: “We have to spend our way out of this recession”. 9 2. South Africa’s Fiscal Response The South African government has released a document in February 2009 entitled “Framework for response to the International Economic Crisis”, which was drawn up by organized labour, business and government. This is the document that is to frame government’s response to the economic crisis South Africa is facing. Like many other governments across the globe, the South African government has recognized the need to embark on government spending and assistance of industries in the economy. The framework of response indicates that the focus of government and business will be divided between 5 measures. These being: 1. Investment in Public Infrastructure 2. Macro Economic Policy Measures 3. Industrial and Trade Policy Measures 4. Employment Measures 5. Social Measures In regards to government direct spending the framework indicates that investment in Public Infrastructure is one of the key means of responding to the downturn in the economy. The framework commits to maintaining high levels of investment in public infrastructure to encourage private sector investment. The R787 billion public investment programme which is to be embarked on by government will remain in place and will run until 2012. The focuses of this public infrastructure spend will be on the following: - Expanding and improving the road and rail networks - Public transport - Port operations - Dams, water and sanitation infrastructure - Low income housing construction - ICT infrastructure - Education and health infrastructure The framework indicates that where possible the maintenance of existing infrastructure and the building of new will be done using labour intensive approaches where possible. The South African government has highlighted that there are two major underlying tenets to the framework of response which need to be born in mind when dealing with the current crisis. The first one is that this economic crisis has the potential to do the most harm to the most vulnerable 10 group in society- these being the low income workers, the unemployed and the poor. In doing so it can further add to the problems of poverty and inequality that we as a nation are faced with. The framework highlights that it is South Africa’s collective responsibility to ensure that the most vulnerable in society are protected as far as possible from the impacts of the economic crisis. The second tenet that comes through very strongly in the document is the focus on creating decent work. The framework points out that during this period of downturn it does provide the economy with the opportunity to prepare itself to take advantage of the next upturn. One of the areas in which change can be affected is in creating decent work opportunities; this implies that we do not only have to increase the level of employment but also the quality. The concept of decent work is one which the current government is very committed to, despite the reservations that many have regarding its impact on the rapidity of job creation. 3. Learning from Past Recessions The question that needs to be asked is, if this Fiscal expansion that is taking place around the globe is the right way to fight the current recession? If one turns to history for directives for current behaviour one learns the following. Wilkinson (2009) indicates that one of the crucial understandings that can be learnt from the Great Depression in the 1930’s is that stimulus spending does help an ailing economy. A paper produced by Romer (2009) presents six key lessons that can be learnt from the Great Depression that would be useful for the global situation at present. It is interesting to note that the origins of the Great Depression and the current recession are very similar. Like during the Great Depression, today’s downturn had its fundamental decline in asset prices and the failure and near-failure of financial institutions. In 1929 like today the collapse and extreme volatility of stock prices led consumers and firms to simply stop spending. The first lesson that Romer (2009) draws from the Great Depression is that during the 1930’s small fiscal expansion had only small effects. She therefore suggests that during the 1930’s Fiscal Policy failed to generate a recovery, not because it doesn’t work but because it was not tried at a large enough scale. Romer, emphasizes in her paper the need for embarking on Fiscal Policy on a scale that is large enough to deal with the recession that it is trying to curb. The second lesson that is brought out from the 1930’s is that monetary expansion can help to heal an economy even when interest rates are near zero. She therefore supports the argument presented earlier in the paper that Monetary Policy does have an important role to play by merely affecting people’s expectations. During the Great Depression lower real interest rates played an important part as they resulted in real fixed investment and spending on durables to increase 11 dramatically during 1933 & 1934 when all other consumer spending barely budged. This shows that lower interest rates can encourage investment spending even during recessionary times. The third lesson that is highlighted in the paper is a warning of cutting back stimulus too soon. Romer (2009) indicates that this is what happened during the 1930’s when in 1937 the US government started to implement contractionary Monetary and Fiscal Policy. As a result of this in 1937, GDP (Gross Domestic Product) only rose by 5% compared to 13% in 1936. It then fell by 3% in 1938 causing unemployment to increase again to 19% in 1938. It is argued that this wrong turn of starting contractionary Monetary and Fiscal Policy too soon added two years onto the economy. Romer (2009) states that it is crucial to monitor the economy closely and be sure that the private sector is back in the saddle before government takes away the crucial lifelines. The fourth and fifth lessons are that during the 1930’s it was seen that financial recovery and real recovery go hand in hand. Therefore during this recession real recovery is only going to occur once one has had recovery taking place in the financial sectors. During the 1930’s it was also seen that worldwide expansionary policies share the burdens and benefits of recovery. Romer (2009) advises that the more that countries throughout the world can move towards Monetary and Fiscal expansion, the better off the global economy will be. It takes a global response to deal with a global crisis. The final lesson that Romer (2009) brings out in her paper is that the key feature of the Great Depression is that it did eventually end and therefore if we embark on the right policy measures now, we will be able to speed up the recovery period of the current global recession. Nobel Prize winner for Economics, Paul Krugman adds further support to the findings of Romer 2009 by his concept of Depression Economics. Krugman termed the phrase of “Depression Economics” to indicate a time period when the usual rules of economic policy no longer apply. He indicates that when Depression Economics prevails virtue becomes vice, caution is risky and prudence is folly. He too cites the example of 1937 when he states that the virtue of fiscal responsibility and concern for budget deficits became a vice and the US’s premature attempt to balance the budget almost destroyed the recovery from the 1930’s depression. Krugman states that during normal times to have cautious policy is prudent. However in recessionary times caution becomes risky because big changes for the worse are happening and any delay in acting raises the chance of a deeper economic disaster. Krugman emphasizes that during recessions, time is of the essence. He is also is a proponent of erring on the side of doing too much during recessionary times rather than doing too little. Too some economists Krugman’s idea of Depression Economics would be anathema, especially to free market economists who would state that if governments wish to see a recession end as quickly as possible then the first and dearest injunction is not to interfere with the markets adjustment process. They would argue that 12 the more governments intervene the more they delay the market adjustment process and the larger and more grueling the recession will become. The moral, social and practicality implications of such free market thinking are vast. As was mentioned earlier, South Africa is already facing a society in which the disparities between the rich and poor are great, we are already facing a situation where unemployment is at unacceptable levels and we are already facing a situation where violence and riots are breaking out due to poor service delivery. If we were now to add the recessionary pressures to this environment and choose not to embark on Fiscal and Monetary Policy stimuli, where would it leave us? Therefore perhaps there are more dangers on the erring on the side of doing too little, rather than doing too much? 4. The Paradox of Thrift “The Paradox of Thrift” was another term coined by John Maynard Keynes in relation to the negative multiplier effect that takes place during a recession due to reduced spending. The main tenet of this theory is that during recessionary periods individuals cut back consumption which results in second and third round effects which deepen the recession. One of the first reactions of consumers during a recession is that they spend less and save more. The result of this is illustrated in this following example. If consumers don’t spend that means retailers and wholesalers don’t make sales, if retailers and wholesalers don’t sell, this means manufacturers have no need to manufacture which also means that they don’t have work for employees, resulting in job loss and so the circularity continues. This abrupt decrease in spending and increase in saving is what is the “paradox of thrift” as thrift is normally something that is held in high esteem in the economy but in this instance it is actually something that can deepen a recession. A recession is caused by a drop in aggregate demand. Therefore proponents of the paradox of thrift theory would argue that if consumers want to improve their economic situation, they should continue to spend during a recession to help get the economy back on its feet. They should then start to increase savings once the economy is up and running again. However this is easier said than done as theory has it that consumers base their spending patterns on rational expectations regarding their anticipated lifetime income. This is precisely what happened during the last decade in the United States. Property prices soared and individuals changed their perception of resource availability over the course of their lifespan. Consumers got into the frame of mind of expecting constantly growing resources in terms of asset price and they therefore spent more money. When asset prices suddenly fell the individual consumer was caught flat footed and forced to reduce consumption and increase savings. 13 The idea of consumption being based on rational expectations of lifetime income has important consequences as it can lead to a situation that is know as a fiscal policy trap. This is a situation where regardless of money that is poured into the economy spending will not go up despite taxes being decreased. Consumers will only choose to increase spending when they conclude that future income warrants an increase in spending. This is where the Paradox of Thrift causes a recession to become self-reinforcing as it is no use in giving consumers greater disposable income when economic rationale is telling them to save it rather than spend it. The Paradox of Thrift once again highlights the enormous importance that expectations have in an economy and that consumers will only spend when they feel safe to do so. As was said by Krugman during a situation where Depression Economics prevails the rules of prudence and virtue change and therefore Obama’s word of “We must spend our way out of the recession” may hold an element of truth for governments and individual consumers. The whole is always a sum of its parts and therefore aggregate demand in the economy is only going to start increasing when consumers and government come to the party. Conclusion In this paper we have seen that recessionary conditions prevail when there is a reduction in aggregate demand in the economy. We have seen that governments have two main tools at their disposal to influence behaviour during recessions, those of Monetary and Fiscal Policy. Lessons from past recessions have shown us that faster recovery periods are achieved if both of these are implemented to try and achieve growth in aggregate demand. In this regard the paper has questioned if in the South African situation we are doing enough on the Monetary Policy side of things and if our strict adherence to our inflation targeting bands is providing a hindrance to a faster recovery period? We have also raised the issue of whether being over cautious or prudent both on the government side and individual consumer side can lead to a recession becoming selfreinforcing. It is true that during a recession time is of the essence and it is government that can play a large role in providing stimulus to a failing economy. Government can also provide the right signals that will influence expectations of individuals which in turn can promote confident spending in the economy. May the South African government not forget that they have a vital role to play in helping our economy out of this present recession. 14