Paul Krugman has been trying to understand why many business leaders support the wrong policies for a nation with high unemployment. He argues that they believe that the state should do what they would do during a turn down in their business. They would try to cut costs by reducing wages and they would cut back on investments. That makes a lot of sense since they don't sell much of their output to their own employees. But what would happen if they did sell most of their output to their own employees? Reducing wages or laying off workers would make things worse. Demand for their output would fall and they would be forced to make further cost cuts. They would have triggered a deflationary spiral in response to falling demand.
Nation states are unlike businesses in an important way. Most of their income comes from employed workers who pay taxes. During a recession they lose tax income and budget deficits will increase as tax income falls. Raising taxes and reducing income support programs would make things worse because households would reduce spending. Falling demand would put pressure on businesses to make further cuts in spending. Unemployment would increase along with falling demand and government deficits would increase in response to declining tax revenue.
In a moderate recession, under conditions of moderate inflation, monetary policy can reverse the recession. The Great Moderation in the US provides a good example. Residential real estate spending is very sensitive to interest rates. The Fed cut interest rates during slumps and new home purchases stimulated spending. When the threat of inflation increased, the Fed raised interest rates and spending on interest rate sensitive product declined along with the threat of inflation. This was called the Great Moderation because the business cycle was carefully managed by the Fed.
The Great Recession was triggered by a collapse in the financial system and the real estate market which had been supported by "innovative" financial securities that created the banking crisis. The Fed cut interest rates to zero but that did little to stimulate spending for new homes as the prices for foreclosed homes declined dramatically. Moreover, inflation fell below 1% as business investment and household spending collapsed. Therefore, it was impossible to reduce the real interest rate below zero like it was in a period with moderate inflation. For example, with 5% inflation, a 1% cut in the nominal interest rate would reduce the real interest rate (nominal rate minus the inflation rate) to -4%. The Fed did what it could to sustain the economy, and low interest rates did prevent a further erosion of the housing market, and asset prices rose in response to low interest rates. However, the recovery from the Great Recession was much slower than it was in previous recessions. The labor market has improved but the recovery has a long way to go.
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