Economist: Should the Fed Prevent Recessions?
Kurt Brouwer August 24th, 2007
Over the past 20 years, recessions have been infrequent. In fact, we have only had two, in 1990-91 and in 2001. Both recessions were mild by historical standards and both lasted only 8 months, which is below average for the post-WWII period (see NBER for more). The definition of a recession is generally held to be two back-to-back quarters of negative growth in the Gross Domestic Product (GDP). However, NBER (the national arbiter of recessions) has a different definition as seen at the bottom of the above-linked page:
‘…a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales…’
Now that we have that squared away, the Economist magazine comes along and in a recent article, asks whether the Fed should just allow a recession to happen.
‘…should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?…
…The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries…’
I think the operative word is the word always in the very first sentence of the article I quoted. The Federal Reserve’s overall mission statement goes something like this:
‘…to provide the nation with a safer, more flexible, and more stable monetary and financial system…’
I don’t see anything about avoiding recessions in the statement. The key words are safer…and more stable monetary and financial system. So, I think it’s fair to say that the Fed seeks safety and stability. As Shelby Davis once said in an interview for our book, Mutual Fund Mastery (Times Business 1997):
“It’s like a good host and hostess at a party. Their job is to take the punch bowl away when the party’s gotten too wild and to restimulate when the economy has a hangover…’They have to know when to take the punchbowl away.
As we have seen over the past month or so, the Fed took steps to ensure safety and stability in the financial system, but they are also not losing sight of other important issues such as keeping inflation in check.
So, I think the answer to the question posed by the Economist is no.
The Fed will certainly seek to keep the financial system on track as it has done for many years. And, as we have seen over the past 25 years, the Fed has gotten better at anticipating problems and that has led to more stability, fewer and milder recessions and solid economic growth. Long may it last.
Hat tip: Brothersjuddblog
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