What kind of recession is this?

All recessions are not created equal.

The current recession was caused primarily by the financial sector assuming very high levels of risk without assuming the attendant responsibility. Financial entities made very risky loans, then insurers such as AIG took on that risk beyond their means to pay. When the music stopped and defaults began, someone was left standing, holding massive amounts of bad loans the insurance companies had insufficient capital to cover.

Did the federal government have to bail out “too big to fail” financial institutions? A case can be made that since money is the lubricant that allows the economy to operate, its flow must be guaranteed. But government guarantees create what economists call “moral hazard”: If someone else is backing your business decisions, why not take big risks for big profit?

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Electricity is also a lubricant, one that keeps businesses and households operating, provided by utilities that are heavily regulated because they are “too big to fail.” Perhaps the financial services sector should be considered a utility and be regulated accordingly?

This recession has proven that a free-market financial sector is not self-regulating. Financial entities must keep some skin in the game, even if it must be forced upon them by government regulation.

Different types of recessions

Some recessions, like the Great Depression and this “Great Recession,” are caused by the demand side of the market, while others are caused by the supply side.

This time, consumers and businesses borrowed too much money; debt loads increased; buying dried up and asset prices decreased; asset values couldn’t cover loan amounts; defaults, foreclosures and bankruptcies resulted; and, finally, businesses and consumers quit consuming.

On the other hand, the recession of 1981-82 was a supply-side problem. In the early 1970s, OPEC quadrupled the price of petroleum, from $3 to $11 per barrel, and President Nixon instituted wage-and-price controls – always a bad idea. When controls came off after a couple of years, prices exploded. Stagflation resulted when prices went up rapidly and demand went down because wages failed to keep up with increasing prices, especially for gasoline.

In 1979, OPEC quadrupled prices again, from roughly $9 to more than $30 per barrel. Fuel prices skyrocketing when the country was more than 50 percent dependent on Middle Eastern petroleum forced industry to become more energy efficient, a supply-side solution. In the mid-1970s, U.S. industry devoted approximately 16 percent of costs to energy supply; by the late 1980s, that was down to about 3 percent. In less than 20 years, industry cut energy input costs fivefold.

A major part of this adjustment was moving production offshore, away from outdated energy-hungry plants, which also resulted in labor cost savings – and domestic unemployment.

Government policies must be different for each type of recession. The best policies for a supply-side recession are tax cuts so investments can be made to increase the efficiency of production so output prices can be controlled and inflation reduced. The best policies for a demand-side recession are Keynesian, to stimulate demand. Consumers must be convinced to spend and be given the wages to do it. Tax cuts to stimulate investment are not effective; it’s like pushing on a wet noodle. Industry can produce as much as possible, but if no one buys, inventories just pile up.

Both types of recessions take time to resolve, but demand-side recessions usually take much longer because consumer debt, caused by excessive borrowing, must be repaid before consumption can increase. The financial sector must reduce its risk quotient by hoarding cash and approving only the very best loans, thus delaying investment and business expansion.

So, when I say it will be 2014 before the Dow Industrials get back to the 2007 peak of 14,164, I’m factoring in the time it takes to flush the excessive risk out of the financial system, get consumers spending, and allow businesses to expand production and employment to further increase consumption.

At the bottom

Just like China, regions like Northern Colorado that were growing well before the recession will resume growing before the larger economy. Infrastructure spending will speed this process, but the nation cannot afford the tax increases that would move things along quickly. The reversal of the concentration of income away from investment and back toward consumption is a politically charged decision that our democratic process is ill-equipped to handle.

The Northern Colorado economy has almost certainly bottomed, barring irresponsible national policies such as trade restrictions. Employment is holding up or growing in the health services sectors, the leisure and hospitality sectors, the alternative energy sectors, the federal government sector, and the local government educational services sector. Resales of existing homes under $300,000 are increasing and new homes in the same price range are beginning to sell. Foreclosures will probably peak in the fourth quarter and new car sales, now at 1999 levels, may have reached a bottom.

Just as it took us several years to build a financial system encompassing excessive risk and irresponsible lending, it will take us several years to dismantle that system and structure regulations that will keep it from happening again.

John W. Green is a regional economist who compiles the Northern Colorado Business Report’s Index of Leading Economic Indicators. He can be reached at jwgreen@frii.com.