Wealth, Equity, and The Recovery

This blog has had two previous discussions about the causes of the 2007 recession.  The first was a post on the merits of Keynes, Hayek, and Fisher in providing an answer to the question of what caused the 2007 Great Recession.  Despite the popularity of Keynes and Hayek in popular editorials, the forgotten Fisher provides the best answer.  Our country forgot the lessons of Fisher and encouraged a bubble in real estate that caused the debt-deflation cycle that we have experienced for the last five years.

The second discussion was a post on Roger Farmer on the role of wealth to create a productive society.  Citing Milton Friedman, Farmer provides the evidence that supports the view that employment tracks positively with wealth.  The more wealth we have as a country, the more employment we have.  With more employment comes more growth and more governmental revenues that provide more services and reduce deficits and debt.

My own research supports the Farmer position.  However, instead of talking about wealth, I use the term equity since I use an accounting view of the economy.  When I look at a statement on the Gross Domestic Product, I see something that is similar in large terms to a national income statement.  And if the country has an income statement, there must be a balance sheet.  I found some data and built a balance sheet going back sixty years.  I analyzed it and saw how equity dropped seriously in the 2007 recession and in the years following. 

Equity is important because it creates the leverage that enables all of us to buy houses and cars and other things.  How many of us postponed a great many purchases because we wanted to repair our own individual balance sheets following 2007?  Both Richard Koo and John Taylor termed this effect as a “Balance Sheet Recession” in their discussions of the Great Recession.  If, from a macro view, the national economy is a composite of our microeconomic behaviors, then our 2007 recession and recovery should reflect the goals of rebuilding our balance sheets.

This brings us to the Stimulus package.  If the cure to the recession is to rebuild our individual balance sheets, then stimulus should enable that to happen.  What did the Stimulus package do?  First, it was a limited series of tax cuts.  Most people used the extra money to pay down debt, which is good, but it failed to stimulate.  In other words, the money was used to rebuild individual balance sheets.  Second, the Federal government transferred money to the states to reduce program cuts.  The Stimulus reduced the number police and teachers that would have been laid off without the Stimulus.  While this is a good thing, it is not stimulative.  In short, this action did not create growth.  The third was a package of road and infrastructure improvements that took far longer to implement than was planned, and the growth effect was diluted.  The sum of these parts is that the Stimulus package did not stimulate very much.  

The reason why this happened is because the policy makers of the time from both parties, including many economists, just got it wrong.  The administration assumed that the recession was basically the same as before.  They did not ask if it was different, and the administration recommended that the medicine from before would cure it. 

The first economists who said otherwise were Carmen Reinhart and Kenneth Rogoff in their book This Time is Different.   They referred to 2007 as a financial recession but they did not offer a prescription for curing it.  We had to wait for people like Roger Farmer to offer a suggestion.

We should also note that as the recession continued, people on their own would improve their balance sheets, which has enabled them to begin buying again.  Once we get back to a national debt/equity leverage typical of the years leading up to 2007, then the economy will begin to approach pre-2007 growth levels.

If we knew then what some know now, the recovery would have been different.