The Two Conflicting Theories of Recession

The “R” word is back in town. Economists and analysts all over the world are now wary about the fact that a major recession may be just around the corner. They have different facts that make them believe that a recession may be about to happen. However, their conclusions are pretty much the same.

For instance, some analysts are basing their conclusions on the sighting of the inverted yield curve which has been touted to be an infallible predictor of recessions. On the contrary, there are some others who are basing their conclusions on the fact that this is the longest that the world economy has gone without a recession since the Great Depression.

However, if a recession is about to come soon, the government must also be prepared to deal with it right! Well, there are two conflicting schools of economic thought regarding recessions. One school of thought believes that it is the government’s prerogative to take the economy out of recession. The other school of thought believes that markets should be left on their own. According to this school of thought, laissez-faire is the best economic policy.

In this article, we will have a closer look at the difference of opinion between these schools of thought.

The Keynesian Approach to Recession

The most popular approach to mitigating a recession was developed by eminent economist John Maynard Keynes. According to Keynes, recessions were the result of exogenous shocks to the economy. This means that the economy normally functions in equilibrium unless a catastrophic event of some type throws the economy off track bringing about a recession.

According to Keynes, this exogenous shock creates fear amongst producers and consumers alike. Consumers drastically reduce their consumption. As a result, producers also reduce the quantum of goods and services being produced. This leads to a downward spiral wherein lesser consumption by consumers leads to even lesser production. Also, when the quantity of goods and services being produced is reduced, people are laid off from their jobs. This accentuates the problem of less consumption.

Hence, according to Keynes, the solution to the problem is government intervention. Consumers and producers are in the grip of fear and hence act irrationally. This is the time when the government must expand its budget and start spending even more money. This increased government spending will counter the reduced consumer spending. Government spending will ensure that production is not reduced and the spiral of recession does not perpetuate.

This is the approach that is followed in most parts of the world. This is the reason why bailouts and stimulus packages are common in the event of a recession.

The Austrian Approach to Recession

Not everybody in the economic universe agrees with John Maynard Keynes. In fact, there are some very staunch critics of the Keynesian theory. One such school of thought belongs to the Austrian economists. Not only do they believe that stimulus packages are useless, but they also believe that these packages are counterproductive, i.e. they make the situation worse than before.

Their approach to recession is totally different. The Austrians believe that recession is not the result of an exogenous shock. Instead, it is the result of bad government policies which interfere with the market and lead to poor investment decisions in the first place. For instance, right now, the government has held the interest rates at near zero levels for almost a decade. During this period, corporations and people have borrowed money and made investments. These individuals and corporations are under the assumption that the interest rates will remain at this level. However, their assumptions are historically inaccurate. It is only a matter of time before the interest rates rise again causing the economy to crash. Austrians believe that the root cause of the boom-bust cycle is in the artificial boom. According to them, government-induced policies are responsible for creating this artificial boom.

Also, they believe that the longer the boom is delayed, the bigger the bust. For instance, when the dot com bubble of 2001 was delayed by expansionist government policies, it led to the housing market crash of 2009. Similarly, since the housing market crash has also been delayed using government money, the economy could be heading towards something even worse.

According to the Austrians, the government must use its tax dollars only to govern businesses. Once it starts interfering in day to day operations, it has to tax more and more in order to sustain its policies. Hence, government spending of today might stimulate the economy today. However, this very same bailout package will have to be paid back with interest tomorrow. This increased interest payment will then be considered as an “exogenous” shock by the Keynesians even though the fact of the matter is that it has been caused by government action.

Hence, according to the Austrians, the best course of action would be to let the markets be free. According to them, any kind of interference backfires in the long run.

To sum it up, the two approaches to recession mitigation have wildly different views. It is believed that a lot of times governments take the first approach for political reasons. They want to be seen as the people who are helping solve the problem even though they may end up making the problem worse.