KEY POINTS:
We are talking ourselves into a major recession. Sure, things are grim, but our own psychology and actions will play a major role in the state of our economy over the next year or so.
John Maynard Keynes referred to the nature of human psychology in determining economic outcomes as "animal spirits". Business and consumer confidence is vitally important in determining the wellbeing of an economy.
Rampant pessimism creates a self-fulfilling effect. Consumers and businesses cut back spending, causing business failures and unemployment to rise, leading to further falls in confidence and spending. Businesses reduce spending on plant and equipment due to concerns about future sales. The economy moves into a nasty downward spiral.
This year's Nobel Prize winner in economics, Paul Krugman, believes the United States' economy is in a liquidity trap. The same phenomenon is at work here.
This term was used by Keynes during the Depression in the 1930s. A liquidity trap is when the loss of confidence of businesses and consumers results in a desire to hold on to cash rather than spend or invest.
This means monetary policy becomes ineffective in stimulating the economy. When the Reserve Bank lowers interest rates this has little impact on economic activity because there is such a low level of borrowing and lending. This appears to be happening at the moment.
A key issue for banks and other lenders at present is the need to maintain their own liquidity in such uncertain times. They want a big pile of reserves in case things turn ugly.
This reduces their willingness to lend. There is also a lack of safe lending opportunities as property prices decline, unemployment increases and businesses struggle.
The other feature that emerges during periods of extreme negative sentiment is called the "fallacy of composition". This states that "what holds true in parts may not hold true in the whole". A common cry being heard at the moment is the need to cut spending and economise during the tough times ahead. While this may be a prudent approach for individuals and businesses, the overall effect on the economy is to make things worse. The loss of effective demand in the economy as everyone cuts their spending results in job losses and further falls in demand and output. Confidence continues to plummet. Keynes recounted this phenomenon during the Depression. He stated that the only remedy in such times was for the government to step in and pump up the economy through its own spending. This would be financed by borrowing if necessary.
Roosevelt's New Deal in the United States was an example of this approach. Ironically, Hitler's rearmament of Germany during the 1930s also proved effective in ending the Depression in that country.
The 1930s Depression ended with the outbreak of World War II in which unemployment in most countries quickly vanished due to massive government spending on the war effort. Government fiscal prudence quickly disappears during wartime.
The world economy is moving into recession and this will impact on us through a drop in demand for our exports. Exports make up approximately 25 per cent of our national income. This means that 75 per cent of our income is determined by our own actions.
In recent years we have been living beyond our means as shown by our gaping current account deficit. The credit that allowed us to do this is drying up but it is not the end of the world. It may be the end of the big imported SUVs, cheap large-screen plasma TVs and annual cellphone upgrades.
This is hardly major hardship. Our grandparents and great grandparents suffered real hardship during the Depression.
The huge growth in unemployment in the 1980s was attributed by many to a rise in the number of shirkers in our society rather than an obvious outcome of the policies implemented during this period.
So far our politicians have been saying the right things regarding government approaches to reducing the effects of the downturn. Increased government spending on infrastructure, broadband access and education are essential parts of a stimulus package for the economy.
A government stimulus package will likely require substantial deficit spending if it is to be effective. If the spending is wise and well directed it will enhance our future national prosperity. Public projects will also be cheaper during a recession with resources available.
Over the past 25 years we have been indoctrinated about the evils of government deficit spending. This is a legacy of the Muldoon era. If this prescription is not followed the alternative will be widespread unemployment of people and capital and a waste of national potential.
* Peter Lyons teaches economics at St Peter's College in Epsom and has authored several economics texts.
