Recession - A Necessary Evil?
Subject Recession
Topic Fiscal Policy
Key Words Recession, Unemployment, Interest Rates, Tax Cuts, Current Account Deficit
News Story

There was some discussion a few months ago as to the 'new' economy being recession-proof. Those conversations have been silenced as new data provide evidence of a slowdown and perhaps recession. The Federal Reserve continues to cut interest rates and President Bush keeps pushing his tax cut, attempting to revive the faltering economy. As this process is evolving, more and more analysts are wondering if a recession is a necessary evil.

The decade-long expansion that the economy has been experiencing has not been without imbalances. Consumer debt as a percentage of disposable income hit its highest level in 10 years at the end of thee third quarter of 2000. Businesses have over-invested in high-tech equipment. Compensation on Wall Street and in Silicon Valley has been excessive. Stock market valuations have been inflated and the current account deficit hit a record $435 billion last year.

Recession can be looked at as a natural correction process, a way for the economy to correct imbalances that have accumulated over the expansion. The alternative, moving too aggressively to prevent a recession may create even greater distortions and delay the inevitable correction. Fed officials are trying to strike a delicate balance in their interest rate deliberations between cutting rates too quickly, which could lead to another run-up in stock prices and consumer spending, and not cutting rates quickly enough, which may lead to a recession.

Another example of this type of dilemma is the record-level current account deficit. If the Fed and the Treasury were to engineer a decline in the value of the dollar, exports would increase, imports decrease, and the current account deficit would fall. However, a sharp decline in the value of the dollar would reduce the value of stocks, bonds and real estate that foreign investors have been holding. A sell-off by foreigners could lead to further declines in stock market prices.

After reviewing potential consequences of aggressive intervention, some economists are concluding that it may be counterproductive to forestall painful layoffs, bankruptcies and corporate restructuring that occur during recession and put the economy back in balance.

(Updated May 1, 2001)

1. How is a recession defined?
2. What typically happens to output, employment, unemployment, wages and prices during a recession?
3. What is a current account deficit?
4. Suppose American consumers were to reduce their purchases of imported goods and put the money into savings. Would this help the current account deficit? What would happen to aggregate demand?
Source Steven Pearlstein, "Is Recession Certain, and Needed?" The Washington Post, March 27, 2001.

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