Why is economy recovery so slow?

Due to the US housing market bubble bursting and various financial instruments that bet on the bubble, we have experienced an economically difficult time over the last three years.  In economic terms, short-term equilibrium of real GDP has been somewhere below full-employment equilibrium, and the difference is referred to as recessionary gap. 

In attempt to bring the equilibrium point back to full-employment point where long-term aggregate supply curve is located, over the last two years, the government has used 1) expansionary monetary policy and 2) expansionary fiscal policy, both of which attempt to shift up aggregate demand curve.

Let’s look at the expansionary monetary policy.  Simply put, it means making a lot of money available in the market, which gives downward pressure on interest rate.  In theory, if the interest goes down, then the followings will go up:
- Business investment,

- Consumers’ consumption,

- Net exports
If these events occur as planned, it will shift up the aggregate demand to full-employment point.  Then, why are we experiencing such a high unemployment rate and still in this mess?  My short answer is that it takes time.

In theory, business investment (e.g. factories, machines and inventories) will go up since they can borrow money at a low interest rate.  That is, their opportunity cost is low.  However, what are the main reasons that they are willing to invest in the first place?  It is because they have confidence that there will be enough demand for their products in the future, which will make the investment profitable.  If they expect that the recession will last long, then they will tend to hold back their investment decisions until they are certain of economy recovery.

By the same token, consumers will, more or less, react in anticipation of future economy status.  In theory, in the case of the low interest rate, consumers’ consumption will go up due to low future accumulated wealth from saving (i.e. substitution effect). However, people have to worry about whether or not they can work in the near future.  There’s a high probability that they get laid off from their companies in recession, which makes them save more and spend less (i.e. income effect).

What about the net exports?  In theory, if domestic interest is low, then money invested in the domestic market will be taken out to invest in another foreign markets where interest rate is high, which makes domestic / foreign current exchange rate low.  This in turn will make exports cheaper to foreign consumers, increasing the net exports.  Is this the case now?  I would say no for the current market.  The investment uncertainty has been higher than ever before during this financial crisis.  What we witnessed was that people flocked to the safest asset, the US government securities instead of moving away from it.  In addition, the world-wide financial crisis made other developed countries implement the same expansionary monetary policy, which made their interest rate low as well.

If neither consumers nor corporations, then who is the one willing to spend in anticipation of possibly long recession?  The answer is the government.  This brings our attention to the second topic, expansionary fiscal policy.  However, it is subject to debate as to whether it should be done in the form of tax reduction or direct government spending.  There are pros and cons on both policies.  For the government spending, it should be carried out quickly enough to stimulate the economy, and should also be used effectively, which is arguably not the government’s strong suit.  On the other hand, the tax reduction should be implemented in a way that it gives enough incentive to beneficiaries to spend it.  If they hold back the tax benefits for the reasons as in consumers and corporations mentioned above, it will only contribute a little to the expansionary policy.

From my perspective, the occurrences of economy booms and recessions are, to a large extent, attributed to two human emotions; greed and fear.  Whether it be recession or boom, the government plays an important role in an era of high uncertainty when nobody is willing to take the initiative, and the timing is also crucial.  But, it just takes time to take effect for those expansionary policies.  Rather than looking at the situation as the end of the world and holding back their cash in fear, individuals and corporations should also see it as once-in-a-life-time opportunity to invest.