Some thoughts on government interventions to prevent recessions

Ruchir Sharma points to a very important point about government interventions to prevent or mitigate recessions and its moral hazard and cushioning effect,

Faith in government as a saviour in recessions has been worming its way into people’s minds for most of their lifetimes. Since 1980, the US economy has spent only 10 per cent of the time in a recession, compared with nearly 20 per cent between the end of the second world war in 1945 and 1980, and more than 40 per cent between 1870 and 1945. One increasingly important reason is government rescues. Combined stimulus in the US, the EU, Japan and the UK, including government spending and central bank asset purchases, rose from 1 per cent of gross domestic product in the recessions of 1980 and 1990 to 3 per cent in 2001, 12 per cent in 2008 and a staggering 35 per cent in 2020. Though the 2020 recession was sharp, it was the shortest since records begin, lasting just two months. Government bailouts in the pandemic came so fast and large that it felt to many people, particularly white-collar employees working from home, as if the recession never happened. Their incomes and credit scores went up. Their wealth exploded with rising stock and bond markets. Now this experience of recession as a non-event seems baked into the professional psyche.

The article also points to the likelihood of a period of higher inflation,

The most lasting legacy of Covid may be its impact on work and wage inflation. One in eight people say they plan “no return” to pre-pandemic activities, including work... In conversations I hear chief executives saying that they have “pricing power” for the first time in decades... Meanwhile, the world is changing in fundamentally inflationary ways: birth rates have been falling for years but are now rapidly shrinking working-age populations. Countries are retreating inward, offshoring to the nearest and most friendly nations rather than to the least costly. The pressure from demographics and deglobalisation will push the new normal for inflation higher, closer to 4 than to 2 per cent.

Some observations

1. On the point about government interventions over the years leading to the build up of excesses, I am reminded of a Howard Marks newsletter (which I blogged here),

In the forestry business, if there's a small fire they let it occur and sometimes they even cause some small fires to burn up the fuel that lies on the forest floor. And if you don't permit any small forest fires, when you finally have one that you can't put out right away, you're going to have a doozy because of all the accumulated fuel on the forest floor.

I believe that if they prevent every recession, that will give rise to such excesses on the high side, it will be, as I say, unsustainable and will cause a recession and that's going to be a doozy. So it just seems to me that if I were running Fed, which I'm absolutely unqualified to do, I would opt for leaving it alone most of the time, the economy, and having it do what it does naturally...We're all in the investment business because we believe in the efficacy of the free market as an allocator of resources. So if you do, then shouldn't you leave the economy and the capital market alone as much as you can so that it can freely allocate resources?

Excessive interventions invariably come in the way of the self-correcting mechanisms of the market, of which recessions are one. However, no matter the logical arguments against such interventions, the political economy of the times cannot help avoid such interventions. In the circumstances, there is little to be done except to endure and face up to the reality. 

2. The normalisation of the resolve (and public acceptance) to undertake such massive interventions by governments also means that they could in theory pull some more cards out to backstop and cushion the next recession, even as more excesses (in the form of debts, zombie companies, financial market distortions etc) build up. Further, the powers and instruments available with governments today (combined with the willingness to use them) to mitigate recessions are more than ever. It may require the later recession to bring the house down. The can could be kicked down the road. 

3. The forces pulling in the direction of higher inflation will have to be seen against those pulling in the other direction. I had blogged here about how the period of low interest rates may continue for long into the foreseeable future. 

4. Besides, I think a steady state inflation of 4% should not be seen as the arrival of a period of higher inflation. Instead it should be seen as a return to more normal times. Instead, the last two decades and more of 2% and below inflation have been an aberration.

Update 1 (28.03.2023)

Ruchir Sharma has more on the culture of reflexive bailouts

In stark contrast to the minimalist state of the pre-1929 era, America now leads a rescue culture that keeps growing to new maximalist extremes... A restrained government was a key feature of the industrial revolution, marked by painful downturns and robust recoveries, resulting in strong productivity and higher per capita income growth. Right into the 1960s and 1970s, resistance to state rescues still ran deep, whether the supplicant was a major bank, a major corporation or New York City. Though the early 1980s is seen as a pivotal moment of broader government retreat, in fact this era was marked by the rise of rescue culture when Continental Illinois became the first US bank deemed too big to fail. In a move that was radical then, reflexive now, the Federal Deposit Insurance Corporation extended unlimited protection to Continental depositors — just as it has done for SVB depositors... In each crisis, rescues held down the corporate default rate to levels that were unexpectedly low, compared with past patterns. They are doing the same now even as rates rise and bank runs begin... The rescues have led to a massive misallocation of capital and a surge in the number of zombie firms, which contribute mightily to weakening business dynamism and productivity. In the US, total factor productivity growth fell to just 0.5 per cent after 2008, down from about 2 per cent between 1870 and the early 1970s. Instead of re-energising the economy, the maximalist rescue culture is bloating and thereby destabilising the global financial system. As fragility grows, each new rescue hardens the case for the next one... constant rescues undermine capitalism. Government intervention eases the pain of crises but over time lowers productivity, economic growth and living standards.