Professor and Chair of Economics Robert Whaples (left) won the Economic History Association's prize for excellence in teaching economic history in 1999. Professor of Economics Allin Cottrell's research interests focus on the history of economic thought and economic planning.
Recovery or recession?
Now that the $700 billion economic rescue plan has passed, what's next for the economy
Professor and Chair of Economics Robert Whaples and Professor of Economics Allin Cottrell discuss what the $700 billion economic rescue plan means for the economy, the global response to the economic crisis, and comparisons with the Great Depression.
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You prefer to call the bailout plan a rescue plan. Why?
Whaples: I think that "bailout" is potentially misleading. It gives the impression that someone is being let off the hook, that someone is being given a lot of money for nothing, that someone's debts are being forgiven. The rescue plan, however, forces those with bad debts to swallow these debts.
How long will it be before the economy improves?
Whaples: The tools of economic analysis don't allow us to be prophets. No one has a crystal ball, so no one knows how the economy will behave in the coming months.
Cottrell: Past experience enables us to make a rough prediction of the timing of the effects of some sorts of policy-changes, but the current crisis is unprecedented and the policies designed to cope with it are new ones. We just don't know how long it will take.
Whaples: It's also important to remember, however, that the stock market isn't the broadest gauge of our economy's health and that it tends to swing around wildly when there's a lot of uncertainty about the future — as there is now. Looking at the stock market can give the misleading impression that the whole economy is headed for the abyss. The broadest measure of our economy performance is gross domestic product (GDP) and it is at an all-time high. GDP grew in the first half of 2008, although many suspect that it began to shrink in the third quarter (July through September).
Cottrell: Agreed, GDP is much more important than the S&P or the Dow. But the GDP numbers come out with a significant time-lag and are often subject to revision. I wouldn't be confident that we know where the U.S. GDP is right now.
Are we already in or headed for a serious recession?
Whaples: Most economists think we're headed for a recession or recently entered one but there's no way of knowing whether it will be mild or severe. It's hard to get an unbiased answer. Many investors, and politicians, will profit from falling markets, so they have an incentive to paint a gloomy picture. Most investors will profit from a rising market and try to paint a rosy picture.
Cottrell: The big unknown is when credit markets will return to something like normality. If the short-term credit that businesses run on remains unavailable, as we've been hearing over the last couple of weeks, there could be a severe recession. If short-term credit springs back, the recession may be mild.
What's your prediction for inflation in coming years?
Whaples: It depends on the source of the recession. If the recession is caused by falling overall demand, like the Great Depression, inflation won't occur. If it's caused by a supply shock (like the soaring energy prices of the 1970s and early 80s), inflation can take off.
Cottrell: The recession that seems imminent is unlikely to be inflationary.
Since you mentioned the Great Depression, how does the current economic crisis compare to that?
Whaples: It's natural to compare any financially uncertain time to the Great Depression. However, I believe the odds of another Great Depression are very low, although not zero. The Great Depression was unique. Economic historians have concluded that the Depression was caused mainly by flawed policies of central banks, including the Federal Reserve, in response to a malfunctioning international gold standard — although additional economic weaknesses and policy mistakes were involved. If you body slam a physically fit economy, will it break? The answer from the Great Depression seems to be: Almost.
Over the years, economists and policy makers have learned from the Great Depression — and other financial crises — a range of policies to adopt to make sure that it won't happen again. Fed Chair Ben Bernanke is a leading scholar of the Great Depression. He and others seem to be avoiding the mistakes of the early 1930s.
What does the rescue plan do to help small business owners?
Whaples: The rescue plan is designed to make credit flow freely again. The credit crunch has caused many small business owners to scramble to line up financing for their day-to-day operations and expansion plans. If the rescue plan works, it'll fix this problem.
In the 1990s, Japan faced a similar financial crisis. Their banks had huge losses on their books because of a collapse of the "bubble" economy, falling land and stock prices. The Japanese didn't do a good job in clearing the debt off the books of their banks and many economists believe this is responsible for Japan's "lost decade" of economic stagnation, which affected small and big businesses.
How will the rescue bill affect the Federal Reserve's monetary policy?
Whaples: The Fed's traditional monetary policy is to control short-term interest rates by buying and selling U.S. government debt. The financial crisis has temporarily made this tool much less effective than usual. Cutting the Fed's interest rate hasn't had the normal effect of putting funds into the hands of borrowers. The rescue plan goes far beyond this day-to-day Fed policy.
In many ways, the financial system is like a body's circulatory system and credit is like the life-blood of an economy. The financial system carries nutrients and oxygen (investment funds) from investors to the organs of the body (businesses). Recently, the otherwise healthy U.S. economy suffered from a serious case of clogged arteries, so credit hasn't been getting through to where it was needed, even though there was plenty of it available. These arteries were clogged because we'd been eating too much junk food — a diet too rich in sub-prime mortgages. The rescue plan ordered by Secretary Paulson and Fed Chairman Bernanke is the equivalent of an angioplasty — designed to reopen the clogged arteries by clearing the bad debt from books of financial firms.
Cottrell: It's striking that the Fed is carrying out entirely new policies. You won't find them in the economics textbooks! Whether and when the Fed will be able to get back to "business as usual" — controlling short-term interest rates via Open Market purchases and sales of Treasury debt — is an open question.
How important is the value of the dollar?
Cottrell: It's not the key issue, but it's of some interest. The exchange rate of the dollar is important because it governs the price of imports, and the size of the trade deficit or surplus. Before the current crisis exploded, the dollar was on a slide. Now, it has strengthened. This seems paradoxical since the U.S. is the epicenter of the crisis, but it reflects uncertainty around the world: all the major economies are affected, and despite its problems, the dollar is more of a "known quantity" than other currencies.
What is the effect of the U.S.'s $10 trillion debt?
Whaples: The official debt is owed to lenders in the U.S. and all over the world. We've wracked up this big debt because the government almost always spends more than it collects in revenue. Budget deficits swell during economic slow downs, so this debt is likely to grow considerably in the near future — especially if the funds for the economic rescue aren't recouped and government investments in financial firms don't pay off. We can shrink the debt by either cutting back government spending or boosting taxes — neither is a politically popular idea in times of economic crisis.
Cottrell: The most worrisome aspect of the national debt is the proportion that is owed to foreigners. The U.S. has been on a consumption spree, financed by borrowing from the Chinese. If at any point foreigners decide that investing in U.S. Treasury bonds is a bad policy we're in serious trouble: the dollar will fall hard and U.S. interest rates will have to rise.
Whaples: It's also sobering to realize that the official debt is only the tip of the iceberg. Expenditures on programs like Medicare, Medicaid and Social Security will soar in the future, unless something is done to rein them in. Some economists calculate that the debt implied by our projected taxation and expenditure plans exceeds $70 trillion.
How does the national debt affect the U.S. position of economic leadership?
Whaples: The U.S. isn't alone in having a large national debt. However, many economists worry that the debt is getting so large that creditors may become wary of continuing to lend to the U.S. government. If so, the interest rate payments on our debt will begin to rise.
Cottrell: The countries of the EU are bound by law to hold their budget deficits to a relatively small percentage of GDP. Is that a good idea? Many would say so, but it does limit the ability of governments to respond to a serious economic slowdown by cutting taxes or raising spending. Sometimes we need deficit spending. But it's hard to avoid the conclusion that the level of deficits in the U.S. poses a threat to our leadership position.
Is it important to have a global response to the economic crisis?
Whaples: Financial capital moves across borders instantaneously these days, so foreign investors hold a lot of U.S. assets and American investors hold a lot of foreign assets. Low transportation and communications cost have also created unprecedented levels of trade. So, for example, if Europe is ailing, U.S. exports will fall and if the U.S. is ailing, Chinese exports will fall. Because the U.S. is the biggest economy in the world (about one-fifth of the world's GDP), we play an especially important role. If the U.S. sneezes, the whole can catch a cold.
Cottrell: Not only did financial institutions around the world buy into toxic U.S. assets, they jumped on the bandwagon and created a bunch of their own. Witness the unprecedented upheavals in the UK, where banks that have been around for centuries are going to the wall. So I agree, the major world economies are "in this together." Given the degree of interdependence, a "solution" for one nation alone is not going to work.
What can people do to prepare for a recession?
Whaples: Have employable skills and a comfortable nest egg spread across a diversified range of assets — and to not live beyond your means. Unfortunately, these are things you can't suddenly do after a recession breaks out.
It's important to remember that recessions have historically been mere bumps on the long-term road to economic success. Even the Great Depression didn't slow down the long-run trend of 20th century economic growth. I polled professional economists a couple of years ago, asking about the long-run prospects of the economy. Almost all said they expect the U.S. economy to grow as strongly in the next 60 years as it did in the past 60 years. If so, average income per person in the U.S. in a couple of generations will be about $150,000.
Cottrell: With regard to "bumps on the road," Keynes famously said, "In the long run we're all dead." Yes, it's likely that average income will continue to rise over the long term but that is not much comfort to someone who's retiring now and finds that the stocks in her mutual fund are worth (say) 50 percent of what she was expecting.
