Policy Choices of the Future

¶ … Policy Choices of the Future Path of the Economy

I left school in 2006 to begin service in South Korea's military. In 2007, many South Koreans were taken by surprise by the news that the U.S. economy was in recession. Moreover, we were taken aback by the collapse of financial institutions like the Lehman Brothers in September 2008, which led to serious financial instability and unemployment. This is because the U.S. is the World's super power with the leading economy that directly influences the global economy. Therefore, this implies that the recession not only caused negative effects to the American economy but also to South Korea's economy. This ripple effect translated to negative consequences like high unemployment rates, stunted economic growth, and volatile foreign exchange rates. During this period, the nation saw a rise in the exchange rate between the USD and KRW from 900.70 to 1,575 between October 2007, and March 2009. In addition, the currency rate increased with 150% within two years, while the national GDP decreased from 5.7% to negative 4.2%.

The sharp rise in the foreign exchange rates and the instability of the economy caused serious negative consequences to people across the world apart from South Korea. The effects of the recession also affected me, since after completing my two and a half year service in the military, I experienced a significant increase in tuition from the Washington University in St. Louis. The College Board's Trends in College Pricing revealed that the costs increased approximately double the rate of inflation. In addition, there was also a sharp increase in the annual average cost of a complete four-year study at an American private university was $36,993. Unfortunately, by the time I completed the military duty in January 2009, the real cost of attending the university had almost doubled due to the high rates of inflation and depreciation in the South Korean currency. In the event, I waited for an additional year to with the hope of joining the university after a reduction in the USD/KRW currency rate. This was a real disappointment since I had looked forward to going back to school to further my education. The only fact that kept my hope alive was the fact that I was not the only one affected by the depression. This is because many of my fellow grandaunts of the year 2009, were not able to secure jobs due to the reduced job market.

Fazzari and Cynamon's article, "Understanding the Great Recession," states that, "Job losses in the U.S. And abroad were the worst in generations." The authors also point out that it would take eight years for the employment situation to recover to the pre-recession status, if the job growth rate was to continue (Fazzari and Cynamon 4). The situation is dire since the rate of unemployment rate in the U.S. is the highest it has ever been in the last 20 years. This is indicated in the rates of employment between 2007 and 2010, where the number of involuntary unemployed Americans increased from 6.76 to 13.99 million. In the second quarter of 2011, unemployment rates were at 9.2%, with one in every ten Americans being an involuntary unemployed. Moreover, Standard & Poors downgraded the credit rating of the nation from AAA to AA+ for the first time in recorded history. This rating is credible, valid and an acceptable means of evaluating the rating of the nation, since S&P is an effective measure of assessing the economic status of a nation. On the other, a more realistic tool to measure the general well-being of a nation is the rate of unemployment. However, a 5% increase in the rate of unemployment does is not significant since more than 7 million Americans lost jobs in the last three years. Therefore, the depression has both indirect and direct effects on individuals and nations. This is because as a post graduate job seeker is directly affected by the recession. This leads to the discussion of the suggestions and sources of the economic crisis. I will also demonstrate that the economic theories are correlated to the recession by analyzing different government policies and economic perspectives. This analysis will extend this model to the analysis of the possible market interactions and methods that could lead to the development and growth of the economy.

Many scholars and academic have suggested different causes for the financial crisis and the recession. Majority of the financial analysts and economists cited the housing market bubble, and excessive advantages in the financial markets coupled with weak government regulations on financial products as the cause of the recession. Most of the economist analysis cites the house price bubble as the main cause of the dynamics that created the recession. Therefore, this leads to the questions of what is the cause of the house price bubble.

The answer to this question is discussed in the article, "Household Debt in the Consumer Age: Source of Growth-Risk of Collapse" by Fazzari and Cynamon. The authors state that strong consumption assisted moderate recessions and boosted growth in the mid 1980s. however, unprecedented household debt culminated into a financial crisis, which threatened the cause of the deep recession. In making this statement, Fazzari and Cynamon identify the mid 1980s as a reference to Minsky Dynamics (1985-2007). To understand Minsky Dynamics, there is a need to look at interest rates of the 1980s not from the recent past. In the 1980s, a few factors are associated with the cause of household financial fragility. The first factor is the innovation of the credit market, and the internet that allowed people to connect to more data and eased lending to consumers. The second factor it institutional changes like tax reforms that made households eligible for securing loans. In this manner, "Cash out" was created to allow households to borrow against existing value of the equity of their homes (Setterfeild 16). In the lecture titled "The Legacy of Hyman Minsky and the Great Recession," Fazzari explains that tax reforms in 1986 gave him an opportunity to have his house as equity to finance his car. Thirdly, are the falling interest rates, which gave way for the practice of mortgage, refinancing. For example, a person with a neighbor that makes the same income as they do buys a huge house they may be driven to think that he or she should buy a house as well. In this factor, people are inclined to follow the consuming behavior of others, which is a changing consumption norm. Fazzari and Cynamon in the article "Household Debt in the Consumer Age: Source of Growth-Risk of Collapse," explain this behavior as, those social norms that inform the individual's utility of consumption. In this behavior, individuals base their identity on their social relations, their views on what they and others should and should not buy, placing an important effect on the manner on which they choose to consume (2). Therefore, when the interest rate dropped during the 1980s, the number of people did not only begin to refinance their home mortgages, but they also borrowed money against their homes easily. In this manner, the authors argue that the changes in the last four decades on the financial and household sector norms regarding the accumulation of household debt resulted in the phenomenon like the "cash out" refinancing of homes. Moreover, the debt on mortgages accumulated in this manner, could, and could not be utilized to acquire durable assets, and can easily be spent on clothing (Setterfield 16). In making this comment, Setterfield criticizes the behavior of people of perceiving money derived from underlying assets as free money by making a comparison of housing wealth with a bond portfolio.

The behavior of consumers led to the increase in housing prices and fewer savings, which led to an increase in spending. The factors caused an increase of 120% of housing prices between 1997 and 2006 as home mortgage debt to GDP ratio increased from 46% to 73% from 1990 and 2008. Of importance is the almost doubling of the mortgage debt between 2001 and 2007. As Setterfield discusses in his article, the mortgage debt, like other debts require servicing. However, many people could not manage their higher monthly payments leading to higher default rates. Consequently, for the first time in 2007 there was a drop in consumption since the 1980s. eventually, the ratio of consumption to income decreased until mid-2011, which Fazzari and Cynamon relate to the Keynesian theory in a statement. They stated that the reduction in home building perspective and consumer spending represents a massive reduction in aggregate demand. This in the Keynesian perspective is an approximate reason for the recession. The economic crisis largely was the cause of the shutting down of extension of consumer credit. This chokes off what had turned out to be fuel for demand expansion in the previous two decades (5).

The focus on Keynesian theory mainly points out that the problems of economic crisis arise from lack of effective demand. As mentioned earlier, during the recession, the balance between aggregate demand and aggregate supply collapses, and the entire economy gets into a deadlock. To increase effective demand, Keynesians believe the government must balance the economy with deficit and increase expenditure. However, the constant alternation between booms and recession is causing the booms to get shorter while the recessions become longer. This phenomenon is the result of empirical evidence that indicates that in the end, the interest rates decrease.

However, this situation creates a problem of capitalism as the rich increase their wealth while financial deficit worsens. Minsky adopted the perspective of Keynesians, hypothesized financial instability, as the finance and money that connects the present with the future, but the future is uncertain. Minsky finds the problem of financial stability is in financing. However, financial instability increases under contemporary capitalism, which increases economic crisis. This leads to the conclusion that to solve economic crisis, there is a need to reduce financing and take up investments in real economy.

This is in contrast to the Keynesian economists that believe on the demand side of the economy. Mainstream economists make the argument that the main driving force of the recession was supply problems like labor market frictions or labor supply shock. Therefore, the Keynesian theory is rejected by mainstream economists, since it proposes the utilization of fiscal policy as a way of affecting aggregate demand as a means to solve economic crisis. Mainstream economists also make the claim that since the crisis was the result of negative supply side shocks, policies that affect aggregate demand have a minimal effect after the aftermath of the economic crisis. In the worst case, mainstream economists believe that an increase in aggregate demand by fiscal policies can cause a rise in deficit for America, and cause debt financing unsustainable.

Mainstream economists form part of the classical theorists that hold the view that limiting the government's role in the economy. These theorists believe that without the government, the economic crisis would not have occurred. They make the claim that the government's fiscal policies increase the rates of interest leading to a decrease in consumption. Eventually, spending on investment also reduces and crowds out of the economy. Therefore, in light of this, classical theorists propose the solution for this crisis as the use of laissez-faire view of the economy. The application of this view in the economy leads to monetary policies controlling short-term economic frictions. Within the four theories that offer different explanations and solutions over the economic crisis, I prefer the views of the Minsky and Keynesian theorists.

This is because from this point-of-view, the economic crisis by definition, is the balance between the aggregate supply collapse and aggregate demand. Nevertheless, the mainstream and classical economic theories assume that the aggregate supply and demand are in equilibrium. Inherently, they embrace Say's law that states that if a society manages supply, another society will match with demand, and therefore, the general supply overflow will exists causing equilibrium within the economy. In reality, aggregate supply and demand are not in equilibrium as they fluctuate continuously. Therefore, any meaningful intervention in the market does not create any equilibrium of the economy. Instead, the utilization of fiscal policies can cause significant changes taken together demand that pushes the economy to equilibrium. Therefore, the interventions of the government using fiscal policies, which are supported by the Minsky and Keynesian theories, in reality stimulate the economy to escape current recession. Moreover, the empirical evidence of Minsky support arguments that is against the use of monetary policies as a means to recovery.

Looking back at the 1980s, it is evident that each time there was a change in the rate of interest or the supply of money, people affect each other to change their consumption leading to negative consequences. In that era, a decrease in the rates of interest or the supply of money increased, people turned to viewing their money as free money and ended up spending more. This excessive spending along with improved financing leads to an unsustainable household debt. This is because more people cannot sustain their debt, therefore, uncertainty in the economy increases and consequently, their confidence. Ultimately, during the boom period the reduced rates of interest created causes the financial system becomes more fragile (Fazzari and Cynamon 17). This evidence is an indication that while monetary policies offer incentives to capitalize on loopholes they do not offer solutions for solving the economic crisis.