Rediscovering The Importance of Liquidity and the Middle Class to the Recovery from Recessions

The Congressional debates during the week ending July 23, 2010 were probably the most exciting in years for many Americans because Congress focused entirely on domestic economic legislation and various economic strategies for recovering from the worst U.S. recession since the Great Depression of 1929. In every representative form of democracy, powerful special interest groups can influence votes; but this month (July 2010) Congress rose above most of these special interests in order to strive to restore the economic health of this country. Two important legislative measures were central to the Congressional debates during this important week: (1) extending the Emergency Unemployment Compensation benefits to millions of unemployed Americans and (2) providing credit to small businesses. These issues had to be addressed because Congress recognized that the extended duration of the current recession required a similar extended commitment to the unemployed; and it recognized that the financial bailout of November 2008 did not reinstate credit to many credit-worthy individuals and small businesses.

Recognizing that Congress has dealt with some complex economic problems over the past year, there are still a few problems that remain unsolved. Specifically, the response from many households and businesses to the limited amount of credit that was available in 2009 was unenthusiastic because some households increased their propensity to save and some businesses waited on the sidelines for better signs of a recovery. During the Depression of 1929, the economist John Maynard Keynes referred to a lack of interest in low interest rates as a ‘liquidity trap’. The ‘liquidity trap’ was Keynes’ rationale for the use of federal deficit spending during downturns in the economy. Prior to this Depression, Classical economists took the position that business cycles were self-correcting which explains why former President Hoover’s administration failed to respond to the needs of millions of unemployed Americans during the Depression of 1929. However, the Depression of 1929 lasted about four years, exhibited unemployment rates that exceeded 20 percent; and showed no tendency to correct itself. Therefore, contemporary Classical economists generally argue that more government raises the cost of doing business which curtails the creation of domestic jobs.

Conceptually, both Classical and Keynesian economic perspectives about the appropriate strategies for revitalizing the U.S economy were central to the Congressional debates during week ending July 23rd. For example, President Obama’s administration and most Democrats favored deficit spending in order to create jobs. That was the purpose of the American Reinvestment and Recovery Act (ARRA). However, the funding for the ARRA was a much smaller version of FDR’s New Deal which ended the Depression of 1929 because Congress may have assumed in 2009 that its bailout of the financial industry would automatically restore consumers’ and investors’ confidence in the economy and the financial markets. Unfortunately, it took many months before even a small share of credit worthy consumers and businesses were able to originate loans from private lenders under more restrictive lending rules. Federal programs that provided credit to first time home-buyers and purchases of automobiles reduced job losses until the funding for these programs ended in April 2010.

Early in July, Congress enacted legislation favoring regulatory reform of the financial industry as a means of restoring credit and confidence in the integrity of financial instruments. In addition, as noted above, towards the end of this month Congress supported the extension of more credit to small businesses. Absence of any legistlation to restore wealth to millions of middle-class American households that lost all equity in their homes and business property remains problematic, however, because depleting the wealth of middle-class Americans, coupled wth the fragility of credit markets are the major reasons that the federal government’s various stimulus programs including ARRA could not reboot the economy in 2009. Therefore, failure to deal adequately with these issues in 2010 will slow down the recovery from the recession in 2011 and beyond.

The important question that remains unanswered today is not whether, but when will implementation of the combination of Keynesian and Classical economic strategies reboot the American economy? Answered like a true economist, it depends on whether Keynes’ concept of a temporary ‘liquidity trap’ is actually a permanent ‘liquidity loss’ today.

Illustrating the difference between a liquidity loss and a temporary lquidity trap, a contemporary Classical economist, Milton Friedman, provided an explanation of household expenditures that conceivably explains the Keynes’ ‘liquidity trap’ as something other than indifference to available credit at low interest rates. He explains behavioral changes that are attributable to liquidity and/or income losses. Friedman argued that there are two components to personal income: ‘permanent income’ and ‘transitory’ income. He argued that households base their expenditures on their estimates of a stable/permanent income stream, as opposed to a transitory component that is leftover (i.e., income generated infrequently as would be the case if the household won a lottery ticket for $5,000). Households rarely base their long-term expenditure patterns on transitory income. Empirical estimates of permanent income are based on something like a moving average which changes slowly over time. Therefore, it is conceivable that piecemeal or insufficient funding for worthwhile stimulus programs could extend the duration of the current national recession. This, in turn could lower households’ estimates of their permanent income which would cause households to permanently lower their expenditure and investment behavior during the recession and during a post-recession era as well. Such behavioral changes would last until a new middle class emerges that has the financial resources to restore domestic employment and production to pre-resession levels.

Unfortunately, absence of a viable middle class produces an economy that would have to be relatively more dependent on federal programs and deficit spending in order to restore growth to pre-recession levels.