Economists Caroline Betts and Robert Dekle share their insights into the nuances of the economy.

Are there some basic economic principles that both individual savers and corporations share?
Caroline Betts, Associate Professor of Economics

Photo courtesy of C. Betts.

Economic theory suggests that individual savers and corporations have rather different objectives. Individuals allocate their income across current consumption spending vs. savings for future consumption spending to maximize their lifetime wellbeing. Corporations allocate labor and machinery, and spending to build new machinery, to maximize lifetime profits. Nonetheless, savers and corporations — not to mention governments and the American economy as a whole — all share a common restriction in pursuing their diverse objectives: they must respect their lifetime budget constraints. Respecting one’s lifetime budget constraint — being “fiscally responsible” — involves some simple, if harsh, realities:

1. If you spend more than you earn, you will incur debt, which has to be repaid with interest.
2. If you incur debt, repayment is facilitated if you invest the borrowed funds in a project or asset that has a positive real return; further, your ability to repay is guaranteed only if that real return is a sure thing.
3. If you are relying on “capital gains,” increases in the price of an asset over time, to assure repayment of your debt, know that capital gains are not a sure thing.
4. If your creditor isn’t monitoring the outcome of your borrowing, your creditor is contributing to a large potential mess — for you — and is probably damaging aggregate economic efficiency.
5. If the culmination of individual, corporate and government borrowing decisions is a large external U.S. debt, be aware that your country’s largest foreign creditor may be its future enemy.
6. Unfortunately, among all economic agents, only a government can force others to repay the debt it has incurred, and that is a sure thing; for a highly indebted government has a single source of income — tax revenue.

How does an economic recession factor into a country’s progress? Is a recession necessary for an economy’s survival?
Robert Dekle, Professor of Economics

Photo credit Taylor Foust.

Economic recessions inevitably occur once in a while. Some economists believe in the “cleansing effect” of recessions. The idea is that periods of prosperity create irrational exuberance, overinvestment, and land and stock market bubbles. Resources such as capital and managerial talent are inefficiently allocated to activities that may not be in the nation’s best interest.

For example, during our last period of prosperity starting in the early 2000s, many talented young people with quantitative skills were attracted to the finance industry. Our country may have been better off if these young people had gone into the sciences or engineering. Recessions, especially one as deep as the current one, brings an abrupt stop in the growth of the sectors characterized by over-exuberance, and may help bring incentives back in line.

Opportunities in finance today are not nearly as plentiful or well paying as before, and talented young people appear to be moving away from finance careers. Thus, by cleaning out waste and by aligning incentives, recessions can be good for a country’s progress, especially if the recessions are short-lived.

If recessions are long-lived, however, they can be quite damaging. Of course, high levels of unemployment are economically devastating to individuals affected and entire communities. Prolonged low growth rates sap a country’s optimism, leading to an overcautious populace. Investment in entrepreneurial and risky ventures declines, resulting in low levels of technical progress and economic growth.

Take Japan, a country that was growing very rapidly in the 1980s, poised for global economic dominance. After its stock and land market bubbles collapsed in the early ’90s, the country went into prolonged recession, with average economic growth rates dropping to less than 1 percent for almost the next 20 years. There is no doubt that prolonged low growth rates have sapped Japan’s entrepreneurial energy, and this lack of energy has made the recovery of growth very difficult.

It is thus very important that a country use all resources at its disposal to escape from a recession as quickly as possible, so that the expectations of the entrepreneurs and the general population can remain optimistic. Once pessimism sets it, and people become over-cautious, it becomes very difficult for economic growth rates to resume. Fortunately, in the United States, fiscal and monetary authorities have been very aggressive in trying to stimulate the economy, so I am confident that the U.S. recession will end soon, and that the country will thus escape the fate of Japan.

Read more articles from USC College Magazine's Spring/Summer 2009 issue.