Business Cycle - Mitigating An Economic Downturn

Mitigating An Economic Downturn

Most social indicators (mental health, crimes, suicides) worsen during economic recessions. As periods of economic stagnation are painful for the many who lose their jobs, there is often political pressure for governments to mitigate recessions. Since the 1940s, following the Keynesian revolution, most governments of developed nations have seen the mitigation of the business cycle as part of the responsibility of government, under the rubric of stabilization policy.

Since in the Keynesian view, recessions are caused by inadequate aggregate demand, when a recession occurs the government should increase the amount of aggregate demand and bring the economy back into equilibrium. This the government can do in two ways, firstly by increasing the money supply (expansionary monetary policy) and secondly by increasing government spending or cutting taxes (expansionary fiscal policy).

By contrast, some economists, notably New classical economist Robert Lucas, argue that the welfare cost of business cycles are very small to negligible, and that governments should focus on long-term growth instead of stabilization.

However, even according to Keynesian theory, managing economic policy to smooth out the cycle is a difficult task in a society with a complex economy. Some theorists, notably those who believe in Marxian economics, believe that this difficulty is insurmountable. Karl Marx claimed that recurrent business cycle crises were an inevitable result of the operations of the capitalistic system. In this view, all that the government can do is to change the timing of economic crises. The crisis could also show up in a different form, for example as severe inflation or a steadily increasing government deficit. Worse, by delaying a crisis, government policy is seen as making it more dramatic and thus more painful.

Additionally, since the 1960s neoclassical economists have played down the ability of Keynesian policies to manage an economy. Since the 1960s, economists like Nobel Laureates Milton Friedman and Edmund Phelps have made ground in their arguments that inflationary expectations negate the Phillips curve in the long run. The stagflation of the 1970s provided striking support for their theories, defying the simple Keynesian prediction that recessions and inflation cannot occur together. Friedman has gone so far as to argue that all the central bank of a country should do is to avoid making large mistakes, as he believes they did by contracting the money supply very rapidly in the face of the Wall Street Crash of 1929, in which they made what would have been a recession into the Great Depression.