Recession Treatment: Monetary meddling or fiscal fiddling?

Introduction:

What action should be taken when an economy 'nose-dives'? At the time of writing, (August 2001), the UK economy appears to be about to enter recession. Manufacturing industry already has experienced two consecutive quarters of declining output and few analysts expect the overall economy to remain unaffected for long.

The evidence from the USA and here is that policy makers appear content to leave demand management to the monetary authorities: the Federal Reserve Bank and the Bank of England, respectively. But how satisfactory is this solution?

This worksheet requires you to select economic data from the TimeWeb sample data, analyse the action taken over the last economic cycle and make recommendations on future policy as the timing and depth of the recession (or lack of it?) becomes clearer. A set of interactive questions is built into the worksheet; try to answer these as you go, to test your understanding of the topic.

The long-lived economic expansion through the 1990s in the USA and in the last five years in the UK, has left the impression that monetary policy alone can be used to control the economy. As the recessionary storm clouds have gathered, both countries seem determined to rely solely on interest rate cuts to steady the economic ship.

Let's first clarify the effects we would expect to result from changing the level of interest rates:

OK, so that's what we are taught happens when the monetary policy levers are activated.

Now, your task is to go to the TimeWeb sample data and retrieve information on UK interest (base) rates over the past five years. The data type you are looking for is called ZCMGMU. Think of an appropriate format in which to display the data.

Right, now try to answer the following questions on what you can see from the data.

Relying on a continued consumer spending boom to insulate the economy from recession may be unwise. Quite apart from the economic effects of the imbalance between domestic consumer demand and industrial output, there is the question of the desirability of persistent consumer debt.

Go once again to the TimeWeb sample data and extract information on consumer credit levels over the past ten years. The data type you are looking for is called RLMHMA. Graph this data.

What does this data indicate about the trends in consumer credit? How does this appear to be related to interest rate changes? Should we also perhaps look at the extent to which quarter, or even half percentage point changes in rates are effective?

The effect on business:

Firms' investment plans tend to be set according to forecast demand for their products and services, rather than being dependent upon interest rate movements: larger businesses tend to ensure that their forecast return on investment satisfactorily exceeds the cost of their borrowing; smaller firms often have to prove to the banks that the rates of return on their investments will be at least twice the interest rate charged.

For further analysis of the tools firms can use to decide whether to invest, you could try the investment appraisal worksheet.

The effect on consumers:

Credit card rates are generally far higher than prevailing interest rates and they generally remain unaffected by short-term changes in base rates. Of course, the housing market may well be affected by changes in mortgage costs, (triggered by base rate movements), but the impact here has to be balanced by the effects of rate changes on savers' incomes.

Interest rates as signals

Movements in interest rates are often cited as being important signalling devices to businesses and households. The thinking goes that a small rise in rates may send the message that more increases may be on the way. Some economists, though, question the clarity of these signals. Boosting rates may conceivably encourage industry to hold back investment plans, as borrowing costs might be expected to get more expensive.

But an alternative view could be that rates are being hiked because the economy is booming, demand is high and therefore businesses should invest now in order to expand their capacity to meet demand. Consumers may read into a rise in rates that they should buy now, rather than when borrowing costs and prices rise further.

Credit availability, not cost factors, may be key

For both business and consumers, the availability rather than the cost of credit may be the most important factor. No matter how low interest rates fall, we as consumers cannot just demand credit from our banks, safe in the knowledge that the banks will lend to us the required sum. Rather, our financial profile is assessed and a decision is made on the basis of the risk involved.

Equally, the attitude of banks to business lending in the face of rate cuts and economic recession, is unclear: will the financial institutions respond to the 'looser' monetary conditions by being more willing to lend?; or are they more likely, on the contrary, to place stricter rules on lending in the face of greater risk of default? The experience of the early 1990s recession in the UK, when many banks were hit hard by bad business lending, may yet prove to have had a prolonged impact on the banks' outlook.

Using the whole of the economic toolkit

Other tools exist, of course, to help tackle the recessionary forces. Opportunities to use fiscal policy measures seem to have gone largely unnoticed, but we have focused on monetary policy here.

The plans of the UK's Labour Government to increase public spending over the next few years, as well as being a political necessity in order to meet election pledges on the National Health Service and Education, may act as a stabilising influence on the economy. Some economists are urging that these increases are brought forward at a faster pace. But there are problems here in actually spending this extra money. Plans to build new schools and hospitals are not easily delivered.

On the other side of the Atlantic, the new Bush administration has already made large cuts in personal taxation. But there are problems here too. Consumers can generally be relied upon to spend a high proportion of increases in their disposable incomes that arise from tax cuts. But these US tax cuts are targeted at the wealthy, who generally have a lower propensity to channel increased income into consumption, than do the less affluent.

Conclusion:

More positive action may well be needed in order to maintain economic demand in the face of a global recession. The full range of policy instruments should be considered. These include monetary and fiscal measures. An over-reliance on interest rate cuts is a dangerous hangover from the monetarist experiment of the early 1980s. Equally, the emphasis on consumer spending as a driver of economic stability is unsafe in the long-term. Over time, what sort of effects would you expect to result from allowing a two-speed economy to flourish (with 'flat' industrial output but fast-rising consumer spending)?

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