Managing economic bubbles before they burst

Managing Economic Bubbles Before They Burst

By Nicole Manuel

Chief Economics Correspondent for SDA Network News

The global economy recently went through a period of unsustainable growth, or what economists call "bubbles." Governments like the United States combat bubbles, and the recessions they induce, by equipping themselves with multiple monetary and fiscal tools to not only stabilize the economy, but also to make the pinch of a recession less painful for consumers.

Let me give you an example. Imagine a flowing, steady pulse beating from a steady heart. The heavy beats (expansions) are separated by lighter beats (contractions). Each beat is nearly consistent and lasting for a similar amount of time. This is called the business cycle. To determine a country’s location within the business cycle, economists refer to the gross domestic product (GDP), which indicates a country's overall productivity. Current levels of consumerism, business investment, government investment, and net exports determine GDP. When the business cycle is disturbed or manipulated, bubbles are formed. Increased government spending during an expansion or pumping more money into an economy during a time of expansion causes prolonged growth and increases the chances of forming a bubble.

In Ireland, to give a recent example, the European Union induced rapid growth by flooding the government with funds, even through decades of growth that ensued. During times of economic growth, contractionary policies ensure long-term sustainability. Pumping money into an economy when it is already rapidly growing is great for the short-run, but it will cause a collapse in the long run. This is what happened in Ireland. After decades of expansionary policies, the global recession shook the foundation of the Irish economy. Ireland was the first country in Europe to be affected by the recession.

When I visited Ireland in 2007, the decline was already visible despite the booming economy. Although construction projects were seemingly everywhere, few new homes were actually being inhabited. The following year, I was stunned by how dramatically construction had dropped. “For let” signs filled city streets. But even though Ireland’s recession officially ended in 2010, the Irish unemployment rate has only now begun to fall. Unemployment is currently at 13.4%.

The housing bubble in Ireland has taught economists that although constant spending on projects to boost consumer morale sounds ideal, it cannot be maintained. Eventually the increased growth will cause rapid inflation. For consumers, high inflation can be just as unpleasant as a recession. After every expansion, a contraction must follow. Contractions are like nausea after eating too much chocolate. It is the market's way of saying, “You've filled me up!” Signs of a contraction include a drop in GDP due to the lack of consumer confidence, an increase in consumer saving, a decline in business investment, and high unemployment.

Most would agree that contractions are unpleasant; however, they are sometimes necessary to balance the economy. Recessions occur when two quarters of negative growth are reported. If the government does nothing to help balance the economy, the contraction will continue and transform into a depression, which is a long-term drop in overall productivity. By cutting off some of the volatility, a smoother economic current can be experienced by both investors and consumers alike.

So what can the government do to smooth the cycle of booms and busts? Our government is equipped with two sets of tools to combat bubbles and recessions: monetary and fiscal policies. Both tool sets are meant to target areas within our GDP to decrease either inflation or unemployment, depending on whether we are in a recession or expansion. Monetary policies change the interest rate and the amount of money floating around in an economy. In the United States, the Department of the Treasury and our central bank, the Federal Reserve, dictates monetary policies. The other tool set, fiscal policies, effect government expenditure on long-term projects and tax rates for consumers. Fiscal policies are dictated by the federal government for the whole country. State and local governments dictate spending for their regions.

The symptoms of bubbles are inflationary prices, high employment, and a seemingly booming economy. Confidence in the economy allows businesses to feel comfortable investing. Due to high productivity, businesses start employing more individuals. People start consuming more goods with their higher income. Imports increase to meet demand. Prices begin to rise as more loans are being made. If not stopped, this seemingly booming economy will collapse under inflationary pressure. Monetary and fiscal policies help prevent and alleviate the symptoms of bubbles by manipulating factors that make up the country's gross domestic product.

To deal with bubbles, a specific mixture of monetary and fiscal policies must be used, both requiring the restriction of the money supply. The Federal Reserve can raise the nominal interest rate, which will indirectly contract the money supply. By reducing the monetary base, The Fed would directly contract the money supply. The Fed also can require banks to hold a higher reserve percentage to reduce the amount available for loans, and thus lower the possibility of high inflation. When monetary policies seek to reduce bubbles, they reduce the GDP by lowering the rates of investment and consumption

Fiscal policies do not contract the money supply; instead, they contract the amount being spent by the government. This principle may go against basic financial logic. Normally, one would think that the government should spend only when they can afford new projects. To prevent disruptions to the business cycle, the government should not encourage a bubble by spending during the expansion. Because people are more willing to spend during times of economic growth, the government should increase taxes so they can afford projects to boost the economy during a recession. Encouraging imports is another way in which the currency can be stabilized. During times of expansion, taxes should increase and government expenditure should decline. This will actually increase the national saving.

During a recession, expansionary monetary and fiscal policies are enacted. Many people might think, “Why don’t we just print more money?” This would be the worst policy we could implement, as it would guarantee inflationary prices and the devaluation of our currency. If our government decided to print money as a way of paying for projects, the purchasing power of the dollar would plummet. A loaf of bread could easily cost $100 or more. Another Great Depression would be imminent. Printing our way out of debt is a policy that the people cannot afford.

Federal Funds Rates (FFR) during a recession will always drop in order to encourage investment. In 2008, for example, the FFR dropped to an all-time low of .25%. When that method had been exhausted, the government then began buying back Federal Bonds so more money would be floating around in the economy; this method is called quantitative easing. On fears of inflation, the Federal Reserve announced in February that it will stop its quantitative easing by June.

Along with these precautions, the government implemented fiscal policies to help ease unemployment and encourage consumption. Expansionary fiscal policy suggests that the government should not cut spending during a recession. The government should, instead, focus on long-term projects that will create jobs for the short-run while ensuring a stable future in the long run. Such projects could include rebuilding infrastructure, investing in healthcare, or creating incentives through tax breaks for clean energy projects. Expansionary fiscal policy also includes decreases in taxes during a recession. People are hurting for money; higher taxes would discourage them from purchasing otherwise important items. When citizens are not confident in their government’s ability to handle the downturn, they will save instead of spend.

Personal consumption makes up the majority of the country’s GDP. Without consumer confidence, the economy will drop —even if all other factors are stable. This fact worries many old-school economists and modern libertarians. Being globally competitive with lower corporation tax is one way to bring business. Another is to encourage export industries. Adding taxes for imported goods only encourages hostility and promotes an image of protectionism, which is terrible for such an influential Western nation. The only factors that can raise a country’s GDP are consumption, exports, business investment, government spending, and tax cuts.