• The Invisible Hand

What To Do in the Next Recession?

Economists are expecting a recession any day now, yet policy makers are totally unprepared

There tends to be a recession every 7-8 years, so given the last recession was over 10 years ago, economists and financial markets are naturally worried, particularly as the yield curve begins to invert (figure 1). However, unlike past recessions policy makers will fight this one with their backs against the wall. The crisis in 2008 was so devastating that the global economy has yet to properly recover so interest rates remain dangerously low and high national debts have made policy makers reluctant to use fiscal stimulus. How then can policy leaders respond to crises given this restricted context?

Figure 1: Spread between ten-year and two-year Treasury bonds: Shaded areas indicate a recession

This post examines what policy makers can do in the midst of a recession when the economy needs to be stimulated.

To intervene or not to intervene?

The main debate among economists in this field is whether to intervene or not to intervene. Keynesians argue economic output is strongly determined by aggregate demand and in a recession the government must use fiscal policy to restore lost AD. However, monetarists such as Milton Friedman (1963) argue that monetary policy intervention causes recessions rather than fixes them. They believe intervention will fail because it is impossible to calculate exactly how much to intervene. There will be a tendency to over-stimulate or under-stimulate, often the former. Friedman would prefer for the money supply to grow at a constant rate, about 3-5%, but he stressed the fact that it was predictable was more important.

In response to this, Keynesians question the efficiency of the market and believe an equilibrium will not be restored in the long-run. The fundamental flaw with Friedman’s theories is that the velocity of money is not constant, and therefore growth is not just determined by the money supply, but also confidence, expectations and real incomes. Fundamentally, Keynes’ maxim that ‘in the long-run we are all dead’ certainly applies because the costs of not intervening are too great.

Figure 2: Velocity of M2 Money Stock

Probably the best argument for intervention is the Great Depression of the 1930s. In the 1930s contractionary policy was used because the government continued to insist on balancing their budget. It was not until WW2 when the depression truly ended as a result of this fiscal stimulus. In contrast, in 2008 policy makers were fairly quick to react; interest rates were drastically cut and President Obama passed a $831bn fiscal stimulus act. This meant while GDP fell by 26.7% during the 1929 recession, it only fell by 5.1% in 2008. It was also less than half the length. The 1930s serves as a good example of how the market is not self-stabilising.

Governments should take advantage of low interest rates in a recession. If a recession is not dealt with by fiscal stimulus, prolonged unemployment could reduce the long-run growth potential of the economy through hysteresis effects. If fiscal stimulus can prevent this, it can easily pay for itself in the long-run, especially as multiplier effects are larger in recessions. Furthermore, if interest rates are lower than the growth rate the government may never need to pay off all its debt so can borrow more. Instead of crowding out, state investment can cause ‘crowding in’ because it improves confidence and a stronger economy means private firms are more likely to invest.

Perhaps the biggest problem is political factors. They both slow down the process and make it more likely to be halted by neo-liberal politicians. In democracies a general rule is that legislatures find it very difficult to make decisions quickly, meanwhile central banks can change interest rates in a matter of hours. It is a slightly smoother process in a parliamentary system such as the UK compared to the US but there are still major constraints.

Politics should by no means prevent sound economic policy, but it should be acknowledged by economists that theory can not always be applied seamlessly.

Fiscal policy

Keynes famously said that the type of fiscal stimulus is irrelevant; he would be satisfied if the Treasury ‘were to fill old bottles with banknotes, bury them… leave it to private enterprise… to dig the notes up again there would be no more unemployment’. However, this essay and Serrato and Wingender (2010) argue that the type of fiscal policy is important, especially for a government with a constrained budget. When the next recession occurs, policy makers should consider using more targeted policies so the fiscal multiplier is larger.

First, generally government spending should be favoured over tax cuts, because individuals have a tendency to save money while government spending is guaranteed to stimulate and provide jobs in an economy. Out of all types of government spending, infrastructure is the best investment because it provides the added bonus of encouraging complementary private investment and it has effects on aggregate supply. However, there is no set rule and tax cuts should not be ruled out. Second, policies should be targeted to affect the poor the most, because unlike the rich, they have a high propensity to spend so the multiplier will be larger. This can also be targeted by giving different states different packages depending on their incomes and therefore their propensity to consume. If fiscal policy organisations follow this plan, fiscal policy can tackle recessions more efficiently.

To overcome the problem of a time lag, automatic stabilisers should be strengthened because this takes the decision out of the political domain. Making a tax system more progressive and strengthening unemployment benefits, will naturally stimulate an economy in a recession without requiring direct interference from central government. Less time will be wasted trying to pass legislation and also recognising if we are in a crisis. This means output is less volatile because a recession is dealt with quicker (figure 3). A more radical approach to strengthen automatic stabilisers could be to link taxes on labour to the level of unemployment, which will also create a bigger incentive on the government to reduce unemployment, but would reduce their budgetary flexibility.

Figure 3: Relationship between strength of automatic stabilisers and volatility of economic activity. IMF

Monetary policy

While fiscal policy is likely to be the big driver of action in the next recession, monetary policy is still important because it has a much shorter inside lag and it does not increase a country’s national debt. However, with interest rates in most countries close to rock-bottom, different monetary policy tools will need to be considered. In the past six recessions in the US, policy rates have been reduced by an average of 5%, but the current federal funds rate is 2.25-2.5% and the Bank of England’s base rate is only 0.75%.

Quantitative easing has been the go-to alternative monetary policy instrument in the recent recession, but it has serious limitations. Primarily, because it focuses on recapitalising banks. This not only rewards those responsible for recessions, but also increases inequality by helping the rich and may not even fix the recession because banks have a propensity to hold onto money in times of uncertainty. QE can encourage animal spirits and restore confidence, but other monetary policy can achieve this is in a much more efficient way.

Instead, ‘Helicopter money’ should be considered, which involves the central bank making payments directly to individuals. It was first mentioned by Friedman (1969) who suggested printing money could always stimulate the economy.. Unlike normal QE this goes directly to citizens rather than big banks, so it does not worsen inequality. Individuals are also much more likely to spend the money, so it is also more effective. Republicans fear hyperinflation, but it is important to remember in a recession there is very little inflationary pressure from a lack of demand, so this is very unlikely. This may sound quite alarming as one of the first rules of economics is not to print money, however, in a controlled and relatively small manner it can be startlingly effective, but it should only be used if fiscal policy and interest rate cuts are inadequate.

A similar proposal in the UK is People’s QE which instead uses a National Investment Bank to use central bank generated money to fund government spending instead of directly giving it to individuals. This can help invest in a more sustainable, innovative economy at the same time as tackling a recession.

Both of these policies impinge on central bank independence, so government intervention in monetary policy will be required if a recession strikes or these responsibilities would have to be further delegated. However, it is time to consider some more radical monetary programmes such as these because QE has some significant failings and interest rates will probably be enfeebled in the next recession.


If a recession does strike central banks and policy makers need to act aggressively and swiftly to avoid long-term damage. Anything short of this will make economic problems harder to tackle in the future. To do this fiscal policy can be made more potent by targeting it to specific demographics and regions. Alternative monetary policy tools can also provide a much quicker and cheaper stimulus while avoiding long-term problems.

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