What happens in a recession?

Jesse Colombo, who claims to be an economic analyst who warned of dangerous post-2009 bubbles, contributed a piece in Forbes titled, “Here’s Why the Philippines’ Economic Miracle Is Really a Bubble in Disguise.” After just a few quarters of rapid growth since last year up to the last quarter that passed, it is still really premature for anyone to say that the Philippines is already a miracle economy. And just because the Philippines is awash with hot money from abroad being parked in local stocks and other short term securities does not mean than when they leave, the Philippines will also collapse because the inflow of hot money is not necessarily the cause of the recent upsurge in Philippine economic growth. Having said that and believing that any rising economy will one day suffer a fall, I would rather discuss here what happens in a recession than pursue Colombo’s thesis.

When the economy is in a recession, businesses are reluctant to invest, leaving many workers out of work or unable to get a raise. Consequently, unemployment increases and total consumption expenditures go down. If the recession is global, net exports is also down. All these declines in investment, consumption and net exports lead to aggregate demand falling behind the usual aggregate supply which is determined by the nation’s factor of production and level of productivity. In a recession, the nation is operating below its potential gross domestic product (GDP).

The potential GDP is what the nation should have produced under normal conditions given its quantity and quality of inputs, level of technology, and organizational or managerial capability to put together all the resources in productive endeavors. In reality, the economy does not move smoothly; the national output fluctuates or moves in cycle. In one or few years, it is running fast, in another time it is running slow or goes into a recession. When the actual GDP figures are plotted in a graph and connected into a line, one could see the line going up or down in some years but the general direction is usually upward. If the trend line is drawn out of the actual GDP line, that line indicates the potential GDP of the country.

When an economy is operating below or above the trend line or potential GDP, it puts many people in trouble. One on hand, if the actual GDP is below potential, many workers will be out of work and those who are lucky to be still at work will now find it hard to get a raise. On the other hand, if the actual GDP is above potential, prices of many products will rise fast. This makes it very hard for poor people to make both ends meet. Under any of these two situations—high unemployment rate or high inflation rate—the government cannot afford to just do nothing and leave everything that happens to the economy to chance.

Thus, when there is a recession, the government is called upon to pump prime the economy. It does this by spending more. This usually requires the government to run a deficit budget. The deficit is financed by domestic or foreign borrowing which is done through issuance of short term securities (treasury bills) or long term securities (treasury bonds). These securities may be bought by domestic and/or foreign financial institutions or individuals.

Like the private sector, therefore, the government borrows money from the financial market. It does this, however, not to compete with the private sector but in response to the declining level of consumption, investment or exports. In that sense, the government is only spending what the private sector is reluctant to. When normal situation returns and the economy is moving forward with the rate of growth more or less at pace with the increase in the capacity of the nation to produce, the government now collects more taxes from a larger tax base and not necessarily through higher tax rates. With more collection, the national debt can now be reduced until the government budget returns to balance.

Some banks which lend money to the national government may actually source part of their funds from the central bank in exchange for treasury bills or bonds that they bought from the government. In that sense, you can also say that the government is borrowing from itself or printing money. No question about this but the government is only doing this for the original purpose of reviving the economy. Of course, some governments may just continue to spend more for the purpose of say, winning an election, but that is another story to tell.

Instead of increasing the level of government expenditure financed through more debts, some would suggest that the government reduce its taxes. The idea is that with lower taxes, consumers will now have more money to spend and the businessmen have the extra funds to invest. However, more taxes in a state of recession or stagnant economy are uncalled for because it only pushes down the economy deeper. Firstly, in times of gloom, households will be reluctant to squander their money, including what they get from lower taxes. Secondly, when the economy is not doing well, businessmen are also reluctant to invest.

Finally, can monetary expansion like the Quantitative Easing (QE) in the US help to expand the economy through the resulting cut in interest rate? The answer is yes if the new funds injected into the system are used for more direct investment. However, during a recession or depression, the animal spirit that prods businessmen to go into new ventures is not there anymore. No amount of cutting the interest rate will encourage one to invest if the expected return is negative or less than the cost of money.

Hence, the only result of quantitative easing is speculative binge in the stock and other asset market which in reality is not what the whole economy is all about. Philippine stocks may double in value because of hot money inflow resulting from the QE in the US but the nuts and bolts or the steel and concrete that make up the factories or businesses that are represented by the stocks are also not necessarily twice in size.