Why Another US Recession Is On The Cards (and possibly worse)

During the recent US political bickering about its national debt, I’ve had many conversations and read many articles about everything from causes to potential solutions to downright frustration. I was thinking about writing an economics focused blog post for a while, and the current debacle has given me some motivation to write about.

So, going back to the title of this post – I agree with those who are contemplating that another US recession might be right around the corner. The one thing we do know for sure is that the US is still in recovery mode from the Great Recession caused by the financial crisis in 2008. And now, we have all been witnesses to the US government being on the verge of default. Thankfully, Congress came to at least some sort of agreement and was able to increase the debt ceiling. Unfortunately, it wasn’t enough to convince S&P Credit Ratings Agency to downgrade the US debt from AAA status to AA+ (basically from complete assurance that the US government would pay the interest on its debt on time to some assurance. The world markets responded in dramatic fashion, with major stock indexes around the world falling more than 5% in single day’s of trading. They financial markets certainly did not behave as if “the US still has an AAA rating”, as President Obama said in a recent speech. I’ll come back to this debt assurance downgrade in a bit

The proposal finally accepted by Congress when the debt ceiling was increased consisted entirely of spending cuts with no tax increases. Right after one recession, such fiscal policy is risky. Unemployment is already high, and GDP growth (economic growth) has relatively stagnated. Because government spending is a direct injection into the economy which increases GDP, from a purely economic standpoint these cuts will hurt the economy more than any equivalent tax increases. Tax increases provide additional income to the government which can be reinvested into the economy. During tough times, people save more and invest less…so by tax increases the government would be reducing savings, and injecting those foregone savings back into the economy. What I’m basically saying is that tax increases would hurt the economy less than spending cuts. Either way though, by trying to balance its budget during non-boom times, the government is risking putting the economy back into recession.

Back to the ratings downgrade – because of all the political bickering on Capitol Hill and an unsatisfactory solution by Congress to the debt problem (complete solution the problem has once again been postponed), The US’ creditworthiness has been put into question. It will now be much harder for the government to borrow more funds in the future, and it will only have to pay greater interest on the bonds it issues. (The US government borrows money by issuing IOU bonds to investors and promising interest on those bonds). With increased borrowing costs, the government will have a much harder time fiscally stimulating the economy the way it did back in 2008…so even if somehow politicians unilaterally accepted that for the sake of economic recovery more spending is needed…the government would only make a lesser impact than with an AAA credit rating.

Another option the government has for spurring economic recovery is expansionary monetary policy…but that has its own problems attached such as increased inflation. Now, inflation would be good for the government as its debts would be worth less, but high inflation would harm the economy overall. Another interesting solution I’ve read about involves the Federal Reserve (the bank the government borrows lots of money from) just forgiving the almost 2 trillion dollar debt the government owes it. This sounds like a great idea, but I’m unsure what negative consequences this would have. Perhaps the Fed’s weakened ability to loan funds to banks?

The fact of the matter is that the US economy is once again in peril. Spending cuts will hurt the economy overall, and tax increases wouldn’t do much better (they would still hurt the economy overall). The government could inflate its way out of debt, but that has potential catastrophic results for the public which suddenly will be able to afford less goods. In my humble opinion, the government should go for a mixture of all three policies and hope for the best in terms of corporate economic growth. Otherwise we may be heading for the collapse outlined so convincingly in this awesome video: http://www.youtube.com/watch?v=Jjv-MtGpj2U

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