UNIT 2. DID AMERICA CHOOSE THE RECESSION?

The late Rudi Dornbusch, an economist at the Massachusetts Institute of Technology, once remarked: None of the post-war expansions died of old age. They were all murdered by the Fed. Every recession since 1945, with the exception of the one in 2001, was preceded by a sharp rise in inflation that forced the central bank to raise interest rates. But today's Federal Reserve is no serial killer. It seems keener on blood transfusions than on bloodletting. When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. The markets are betting it will soon cut its main federal funds rate. Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it? Most people think the question smacks of madness. According to received wisdom, the Fed should not cut interest rates to bail out lenders and investors, because this creates moral hazard and encourages greater risk-taking; but if financial troubles harm spending and jobs the Fed should immediately ease policy so long as inflation remains modest. Central bankers should be guided by the Taylor ruleand set interest rates in response to deviations in both output and inflation from desired levels. But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows? Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a houseprice boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time. Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump. From The Economist, August 23rd 2007

1. After reading the text, try answering to the following questions: What would be the economic advantage of induced recession? State the connection between the increase of inflation and the central banks need to raise interest rate.

How would affect the cut of discount rate both lenders and investors? How can a central bank try to avoid recession? State the connection between recession and moral hazard? When do consumers, firms, investors, borrowers take bigger risks? In recession or expansion? State the connection between interest rates, equity, mortgages, demand. Whose job is to prevent recession? Whose to benefit/whose not from slashing interest rates? Whose to benefit from recession? What about from expansion? State the economic impact of both. Whats the dotcom bubble burst business and how did this affect the American economy? What would an expansion do in the American economy right now? What are the consequences of induced recession?

2. Mark the following statements as true or false; explain your choice: The economic costs of recession are: unemployment, lower profits, bankruptcy. The consequences of recession are: lower interest rates and lower reserve requirements. Recession is sometimes a benefit to the economy: only well-run companies are still on the market when the crisis passes on. Zero interest rates assure companies more elasticity in case of a recession. Zero interest rates boost economic growth. A recession forces people to restrict their spending, borrow less, therefore it purges the excess. Recessions always reduce trade gaps.

3. Decide which of the two options is the right one: A recession is preceded by a rise/fall in inflation. During a recession the National Bank has to increase/decrease interest rates. A very low/high interest rate drags an economy into recession. The subprime mortgage crisis affected only the American economy/the global economy.

The reduced/increased interest rate encourages risk-taking and on the long run, it damages the economy. The interest rate should/should not match the level of inflation. People borrow more/less and save less/more if they think that the Central Bank would prevent them from any financial risk. Inflated/light demand generates inflation, if not controlled by the interest rate. If the Central Bank wants to increase/decrease interest rates, it sells/buys government bonds; then the money supply increases. By increasing/decreasing reserve requirements, the Central Bank gives different banks the opportunity to decrease/increase loans or sell/buy different assets.

4. In groups of two, brainstorm so as to provide answers to the following questions: Provide examples of Romanian recessions. Were the economists using the same instruments as the Americans? Summarize the American situation in 2001 and compare it with the Romanian in the same year. Is the Taylor rule applicable in Romania? How does affect the cut of discount rate both lenders and investors in Romania?

5. Decide the type of risk of each kind of the following investments has during recession; use L for low, M for medium and H for high to specify the risk involved: Deposits in commercial banks Deposits in insurance companies Deposits in pension funds Investments in real estate Credits in commercial banks Securities on the national market Mutual funds in emerging as well as developing markets Equities in investment funds

6. Analyze the Romanian economic situation in the last twenty years. Enumerate all possible interventions the Romanian National Bank used to control recession and expansions. State also the main financial instruments used to reach the respective target.

Task 1 How do aggregate demand and output fluctuate when a national government chooses to borrow abroad and spend the money on necessities?

Task 2 Can a government choose to start up different public works during recessions?

Task 3 What phase of the business cycle is in your country right now? What is the current fiscal policy? What tax and expenditure policies seem appropriate?

UNIT 3. FINANCIAL CRISIS

When times are hard, many people are tempted to let their credit cards take the strain for a while. And when economies fall into recession, many governments are happy to let their budget deficits widen, to tide the economy over. Sensible as this may be, deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt. Market pressure explains why deficits have come to the fore in southern Europe. Greece and Portugal, in particular, have seen a sharp rise in their cost of finance and some investors have questioned their ability to roll over their debt. But deficits will also be at the centre of the forthcoming British election campaign, and in America the tea party movement has launched a populist campaign against rising government spending. There is no absolute rule on when deficits or public debts are too high relative to an economys size. Prior to the crisis the general consensus was that rich countries could safely have public debts worth 60% of GDP. Yet although Japans debt has exceeded its GDP for many years, the government has yet to suffer a financing crisis, perhaps because it has a large number of willing domestic buyers of its bonds. But when the markets do lose confidence in a governments fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions. Plainly, economic growth makes policymakers lives much easier. Growth reduces deficits automatically by increasing tax revenues and cutting spending on unemployment benefits and so forth. As the economy grows, deficits fall, debts become more sustainable, lightening the adjustment burden and reassuring investors. Nations have recovered from huge debt burdens in the past, often in the aftermath of wars, when men and resources were released from conflict and put to more productive work. When politicians turn to todays deficit problems, it is vital that they choose policies that enhance long-term growth prospects. They will not lack opportunities: in several countries, for example, increases in statutory pension ages and other reforms that make labour markets more flexible are anyway overdue. So, short of debt default or implicit default via inflation, that leaves two other ways of closing the deficit. Spending must be cut or taxpayers must pay more. Many political battles of the next few years will be fought on these simple lines, with taxpayers on one side and the beneficiaries of public spending on the other. One imminent battle will be between taxpayers and public-sector workers. In some countries, one party can be seen as representing taxpayers (the Conservatives in Britain and the Republicans in America) and the other the workers (Labour and the Democrats, respectively). Another of these fights will be between generations. In America the biggest mediumterm budget busters are pensions and health care for the old. A big deficit may ease the economic pain in the short term but risks saddling the next generation with a growth-sapping burden of higher taxes and interest payments. The battles are also intertwined: taxpayers finance the pensions of public employees which are, by and large, more generous and predictable than in the private sector. The outcome of these battles will vary from country to country. Both sides have potent weapons. Many of the biggest taxpayers are political donors and have access to people in power. If they are ignored, they may pack up and move to a more friendly jurisdiction. In Europe especially, public employees, together with recipients of public services, probably have numbers on their side. They are certainly better organized, via their trade unions, and

they are political donors too. As French workers have often shown, public-sector unions can intimidate governments with strikes and demonstrations. Their Greek brethren have been trying to emulate them. From The Economist, March 4th 2010

1. After reading the text, try answering to the following questions: Why, during financial crisis, people are against rising government spending? What is the pressure markets exercise over budget deficits? May an economic crisis be determined by a political one? Before the crisis, rich countries could have a public debt higher than their GDP. What does it mean a public debt and how could they manage this situation? If the public debt is owed by international buyers, could this situation save a country from a financial crisis? What are the measures by which a deficit may be reduced? Does public spending have to be encouraged in order to put an end to a financial crisis? What about social measures? The young generation has to pay higher taxes and higher interests in order to sustain the pension and health care systems. Does this create disputes between generations? In a country there are usually two major parties, one representing the old generation (higher pension funds etc) and the other the young generation (protecting the taxpayers rights). Is there the same picture in Romania? 2. Decide whether the following statements are true or false: Governments should concentrate themselves on tax increases in order to stop recession. Cuts in public investments tend to put an end to recessions. The fall of inflation and of interest rates are slowing down the budget deficits. Cutting spending may encourage the boosting of the capital market. The end of the cold war changed substantially the spending policy in the Western countries. Nowadays, they invest more in the social security system. Governments depend on supporters, so they vote policies which encourage employment rates. The government should not always act in the interest of the population.

There is a difference between the interest of the population and the general interest of the economy. If a country wants to repay its debts, it has to tighten its fiscal policy, thus damaging the interest of the population. A market controlled by domestic investors gets easier out of a financial crisis. By devaluing the national currency, the recession could be easier controlled and surpassed. Big tax increases can damage the economy. Countries are also afraid of increasing taxes, because of tax heavens such as Switzerland etc. Sales or VAT taxes are a solution to decrease the budget deficit, but they are often to be paid by the rich.

3. In each case, which of the two statements is true: a. Tax rises and freezing wages are a way of controlling recession. b. Tax rises and freezing wages are a way of controlling inflation a. Tax evasion seems to be the problem of Eastern European countries. b. All the European countries confront with tax evasion. a. The IMF dictates harsh measures for Eastern European countries, measures which are not applicable by the governments being afraid of strikes and lost of votes. b. The measures imposed by the IMF, in exchange for its loans, are strictly respected by local governments. a. Autocracies are better because they assure a low unemployment rate, subsidies for factories, but limited property rights. b. Democracy is still the most popular system worldwide. a. A good proportion of the European population is in or nearing retirement, so the public pension system has to be supported by more and more taxes paid by the young population. b. A good proportion of the American population is in or nearing retirement, so the public pension system has to be supported by more and more taxes paid by the young population. a. The population is divided into two classes: taxpayers and people benefiting from public pensions. Government usually supports the latter.

b. The population is divided into two classes: the taxpayers and the people benefiting from public pensions. Government usually supports the former.

4. Choose the appropriate words in the following statements: The capital markets are eager to restart their business especially in the Eastern/Western European countries. Greece/Romania recently announced an austerity package. Greece and/or Romania are considered to be the most corrupted countries in the European Union. Japan/America has high debt levels. The richest countries in the world are the United States, Japan and/or Germany. Who is to support the cost of the current recession? Taxpayers, retired people, future generations/foreign investors. Protectionism/free trade is the solution to solve out the economic crisis. More flexible labor markets may boost/damage to the economy. Spending cuts/tax rises do better to the European economy. Countries are tempted to diminish their debts through higher/lower inflation. Loose/tighten credits gave way to an era of austerity. The 2008 crisis was a banking crisis/pension crisis. Helping people to borrow money is not doing them any good/is making them a service. The American crisis in 2008 was/was not similar to the American crisis in the 1930s. The European continent is more/is less affected by the 2008 crisis than the American one.