The 2001 US Recession- What Makes it Different?

  "There are a lot of things you can say about the Bush Tax Cuts, but you can't say they didn't work."   - Phil Gramm

Economists describe a recession as an over-all decline in economic activity that leads to a contraction in the business cycle. Generally, two consecutive quarters of negative real GDP growth is termed as a recession, and as history points out- a prolonged recession has severe adverse effects on the livelihoods of people across all sectors of the economy, due to high unemployment rates, fall in income, increase in poverty and numerous other effects. Thus, it becomes essential that the government and central bank enforce effective stabilization policies to resolve the crisis.

The United States faced a recession in 2001, as the Gross Domestic Product (GDP) had negative growth for the first 3 quarters, starting in the month of March and ending in December. (NBER, 2003)

Quarterly U.S Real GDP Growth Rate (1999-2002)

Source:  U.S. Bureau of Economic Analysis (2020)

There could have been severe adverse consequences as in the Great Recession of 2008, but in this case, prompt monetary and fiscal policy corrections limited the severity and duration of the recession. When compared with the several post-World War II era recessions, the comparatively short duration of the recessionary phase, makes this case stand out from others. In order to analyse the effectiveness of the policy response, we first identify what caused the negative GDP growth.

Causes and Consequences of the 2001 US Recession

One of the key indicators of an economic recession is a fall in consumption expenditure, as it is a major component of aggregate demand. However, another differentiating factor of this recession, is that although consumer spending had a relatively weaker growth rate in 2000 and in the early months of 2001, consumer durable goods purchases rose strongly well into the 2001 recession. (Kliesen, 2003).

Source: World Bank                       

            There are primarily two reasons for this-

    1)  An increase in levels of household wealth, outstanding GDP growth rate and low unemployment level of the 1990s restricted a severe decline.

 2) A prompt monetary policy response prevented a sharp decrease, as we will see later.

Thus, a decrease in consumption demand and new residential housing, which was also increasing during this period was NOT the major cause, but instead a sharp decline in investment demand was to blame.

A sharp contraction in investment can mainly be attributed to a decline in non-residential investment. The collapse of the Dot-Com Bubble which was fueled by extreme speculation and overvaluation of technology stocks, and was termed by the then Federal Reserve Board chairman, Alan Greenspan as “irrational exuberance” was a major cause. Secondly, the economic impact of the 9/11 attacks in US, such as the closing of the stock exchange for several days, added to the decrease. Finally, various economic scams such as the Enron scam further led to the loss of confidence in the economy. Thus, the major cause of the recession can be attributed to the decline in investment demand. 

The primary effect of the recession was on employment levels and investment demand in the economy. Unemployment levels increased from 4.1 % in January of 2001 to 5.7 % at the end of the year.     

 

The consequence of the lowering of investment demand is analysed through the IS-LM framework. Thus, representing the decrease in investment demand is a leftward shift of the IS curve. The decrease in income as a consequence of lower investment demand also lowers interest rates.

Where ‘r’ in the y axis is the interest rates and ‘Y’ in the x axis is the Gross Domestic Product

Policy Response to the 2001 Recession

Monetary Policy

The Federal Reserve Bank (FRB) promptly enacted an Expansionary Monetary Policy to control the degree of economic contraction. On January 3, 2001 the FRB announced its decision to reduce the federal interest rate to 1.75% (Federal Reserve Release, 2001), which is a significant decrease. 

By reducing the short-term rate of interest, the FRB reduced the borrowing cost to commercial banks and consequently, the banks lowered the rate of interest that they charge back to the consumers for loans. Thus, the significant reduction of interest rates led to an increase in the money supply in the economy.

 

Source: Board of Governors of the Federal Reserve System (US) (2020)

The reduction in interest rates accompanied by an increase in money supply leads to an increase in investment expenditure and interest-sensitive consumption expenditure. This is represented by the IS-LM framework by a rightward and downward shift of the LM curve-

This expansionary monetary policy has no effect on the IS curve, and due to the shift in LM curve, the fall in interest rate raises investment demand, thus having a multiplier effect in raising consumption

Fiscal Policy

There was also an effective usage of fiscal policy in reviving the economy. The 2000 United States presidential candidate George Bush, when asked about taxes, stated "This is not only 'no new taxes,' this is a tax cut”. The government introduced a series of tax relief measures in 2001, which came to be known as Bush Tax Cuts. The central tenet of Keynesian Economics is that government intervention by fiscal policy stabilizes the economy, by raising aggregate demand.

                                             

Source: Organisation for Economic Co-operation and Development (2020)

The reduction in tax was accompanied by a simultaneous increase in government spending. There was an approximate 1% increase in government expenditure as a percentage of GDP from 2001 to 2002.

                               

Source : U.S. Bureau of Economic Analysis (2020)

As a result of the decrease in tax rates , a horizontal shift that occurs in IS curve is calculated by the value of the Tax Multiplier times the reduction in taxes (ΔT),

ΔT x MPC/1-MPC

 The rise in spending by the government, and the consequent horizontal distance between the two IS curves that is generated by the rightward shift of IS curve is equal to the increase in government expenditure multiplied by government expenditure multiplier

ΔG x 1/1-MPC

     

Where ‘r’ in the y axis is the interest rates and ‘Y’ in the x axis is the Gross Domestic Product

Analysing Policy Effectiveness through IS-LM model

The paper has analysed the IS-LM framework of the 2001 United States recession, through a representation in three different stages-

1) A decrease in investment demand leading to a leftward shift of the IS curve from IS 1  to IS 2 .

2) The Expansionary Monetary Policy Response by increasing money supply and reduction of interest rates, has led to a rightward shift of LM curve from  LM 1 to LM 2 .

3) The Expansionary Fiscal Policy Response by reduction of taxes and increasing government expenditure has led to a rightward shift of the IS curve from IS 2 to IS 3 .

Thus, integrating the 3 stages to analyse the policy response, we find-

Where ‘r’ in the y axis is the interest rates and ‘Y’ in the x axis is the Gross Domestic Product

    

The Expansionary fiscal policy implemented by the government which included a rise in government expenditure and a reduction in taxes, led to a widening and increase of the government budget deficit. Moreover, as seen in the previous figure, the expansionary policy led to a rise in interest rates from R3 to R4, leading to a contradictory, although minor decrease in aggregate demand, due to reduce in business investment as well as household consumption. However, this leads to comparatively lesser effectiveness of the policy response. This macroeconomic phenomenon is referred to as “crowding out” effect, which weakens the impact of fiscal policy.

Here, the monetary policy response during the 2001 recession has played an important role in countering this crowding out effect, as it led to a downward pressure on interest rates, and thus largely offset the impact of the crowding out effect.

                                                    Conclusion

The presence of sticky prices makes an instantaneous adjustment of the markets extremely difficult, however it enables a policy response to change aggregate demand, and boost the real purchasing power during an economic recession. The empirical analysis of the 2001 US recessions, found that the magnitude and duration of the negative GDP growth rate had been effectively stabilised by an expansionary monetary and fiscal policy. The timely monetary response by the Central Bank has also led to a comparatively lesser impact of the crowding out effect and has ensured that the recession doesn’t persist for a longer duration.

 References:

Balcerzak, A. P., & Rogalska, E. (2014). Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them? Economics & Sociology, 7(2), 80-93. doi:10.14254/2071-789x.2014/7-2/7

Froyen, R. T., & Greer, D. F. (1989). Principles of macroeconomics. New York: Macmillan.

Friedman, B. (2000). Monetary Policy. doi:10.3386/w8057

Gupta, A. (1976). How Fiscal Policy Can Help Employment Generation. Economic and Political Weekly, 11(17), 631-636. Retrieved August 2, 2020, from www.jstor.org/stable/4364569

Kliesen, K. L. (2003). The 2001 Recession: How Was It Different and What Developments May Have Caused It? ICPSR Data Holdings. doi:10.3886/icpsr01292

Musgrave, R. (1972). Fiscal Policy. Proceedings of the American Philosophical Society, 116(3), 197-202. Retrieved August 2, 2020, from www.jstor.org/stable/986114

Monetary Policy and Financial Stability. (2015). Policy Papers, 2015(45). doi:10.5089/9781498344265.007

What kind of recession was 2001? (n.d.). Retrieved August 02, 2020, from https://www.economist.com/free-exchange/2009/08/11/what-kind-of-recession-was-2001