Economind Explains: Recession

First draft: 11th Jan 2017

Final revision: 13th Jan 2017

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One of the bizarre things about economics is that it exists in the realm in-between know and know-not for many people. At least, that is how I used to perceive the discipline. Having spent some years in and out of formal economic training, I have come to a realization that the prior statement is not (entirely) correct after all. The subject is actually quite well-known, to the point that it is widely reported and discussed on the news every single day. And, if you frequent café as much as I do, then you are bound to encounter a round table or two with economics in the middle every so often. It turns out that my statement needs a bit of adjustment, call it semantic if you may.

Economics is one of the most well-known subjects due to its relevance to people’s life, I now reckon. But, it is also one of the least understood. Odd as it may sound, the assertion seems to hold pretty well even at the highest level of social and academic hierarchy. Unlike in natural science where it is extremely hard to establish any claim of one’s expertise unless the person has dedicated years in the field, economics usually gives off the aura of familiarity. To put it in another way, the scientific realm is out of common reach and its immediate pertinence to the livelihood of ordinary citizens is, for the most part, obscure. Of course, people have a good idea that science is central to progress, but how exactly, that remains a difficult question for most. Hence, hard science often induces humility in a person. With regards to social science, on the other hand, things tend to get a bit more complicated. Economics, in particular, seems to follow (or so people think) common sense. To most, economics 101 kind of does the job for them because it teaches the basic traditional economic models as well as the tips and tricks in economic thinking. Except, this is far from being adequate.

Let’s just take “Recession”, today’s topic, as an example. Recession is one of the most discussed, most well-known, and again, least understood subjects of them all. The general public usually takes recession as a period of economic hardship, a downturn in the zigzag squiggly GDP graph. It is deemed a time of widespread unemployment, gloom and panic. Economics 101 expands further upon this shared perception. Recession, in introductory economics as in many other online sources, is formally defined as a situation when the economy experiences negative growth for two consecutive quarters. Well, this doesn’t help much, and back when I was a first year student, I took it at face value. Only during my second year did most classes talk further and elaborate on on the subject by discussing about inventory surplus built up by the producers, about the fall in aggregate demand, the loss of confidence in the bear market (Bull thrusts its horn up, so bull market is when the economic trend is up; Bear swipes its paws down, and thus, bear market is when the economic trend is down), about drying up credits and the likes as the symptoms and/or consequences of recession. In that sense, the upper year courses did provide a fair amount of content to elucidate the idea and clear up much of the false preconceived notion. Still, there has been some confusion generated by these attempts. Not to mention, most people barely grasp the 101 concepts presented in their mandatory economic class (that is to say economics 101 tends to get too mathematical/technical), and there are millions others who have no formal economic background at all. Furthermore, what is funny about the widespread misconception held by the public today is also that it seems to be encouraged and sustained by economics 101 itself, probably due to the underlying nature of economics. How? Most likely because economics can be made sense of in various ways, and people like to invent their own method of gripping economic phenomena. This is exactly what has been happening again and again.

The Great Depression’s Memorial Site in Washington, D.C.

Many economists think that recession is due to people demanding less than they produce, or more technically, aggregate supply outstripping aggregate demand (i.e., excess supply). This is all fine and uncontroversial, but as to what causes this phenomenon, opinions differ. There are two major routes that could be responsible for such an outcome, either because there is too much supply or too little demand. While the latter sounds like I am reciting things backward (intuitively, surplus in supply necessarily implies shortage in demand), from where the source of the problem stems (supply- or demand-induced) really makes a huge difference in how we should perceive and treat the ailment. As for the former, some think that consumerism is responsible for the crises since consumerism is conducive to overproduction and supply of unproductive/luxurious goods and services. For the latter, there has been persistent belief that immigration and outsourcing of labour ushered in by globalization are responsible for the falling level of domestic employment; thus, decreasing aggregate demand. Some also think that labour-displacing technology (i.e., technological improvement that promotes capital-intensive and knowledge-based economic state) causes demand to fall short of supply. Yet, they never bother asking one fundamental question: “Does it even make sense to say that we demand less than we supply?” or “Is it possible to overproduce?”

If you think otherwise and never question the teaching, this should be a surprise to you because it implies that information is clogged somewhere along the line and has never been conveyed properly. In fact, the puzzle of recession has already been vanquished. “Recession” was no longer an esoteric knowledge since a little less than a century ago when the world renowned British economist, John Maynard Keynes, delivered his masterpiece – a book entitled “The General Theory of Employment, Interest and Money” – that sheds light upon the rationale behind the unstable economic system of the early 20th century. As explained by Joseph Heath – a Canadian philosopher at the University of Toronto (whose passion in economics is nothing less than admirable) – in his book “Economics without Illusions”, recession is like a glitch/bug in capitalism rather than a self-contradictory structural defect peculiar to the system itself. To blame it on capitalism (which is usually confused with consumerism) is thus incorrect. Actually, contrary to some popular beliefs, the structure of capitalism remains pretty much intact. There has not been any radical change to the system (or the much accused consumerism), but rather tweaks that fixed the glitches. To say consumerism is the main cause of recession is thus a fallacy because communism and socialism, devoid of the so-called consumerism, have experienced worse. Also, even with capitalism, it used to be that recession (and its more evil brother, depression) happened once every several years, but with the exact same capitalism structure nowadays, it is no longer the case. What has changed since 1930s that allows for a much less frequent occurrence of recession is the better understanding, management, and prevention of the problem by the government. You may not have noticed, but fine-tuning capitalism has been one of the greatest achievements by our kind (but the success is of course more prominent in the west).

At this point, the proponent of overproduction fallacy might jump off the chair and start pointing at the logical deduction that consumerism leads to a race to the bottom, a self-defeating collective behaviour, as people continue to bid up price, and thus, send the wrong signal to producers to produce more than actually needed. “Not so fast!” I say. In economics, there is something called “Say’s law” put forth by a French economist, Jean-Baptiste Say. What Say’s law “says” is that a general glut in the economy cannot happen for the reason that aggregate production necessarily generates an equal aggregate demand. Consider a simple economy with pen and apple. The only reason producers of pen work at all is because they want to consume apple. Likewise, growers of apple need recompense for their effort which is, in this case, pen (hence, the terms “apple-pen”).

In all seriousness, Not this Apple-Pen!

Joke aside, what this implies is that in an economy, there cannot be overproduction because pen is always exchanged for apple and vice versa. If there is too much pen on the market, what will happen eventually is that the price of pen will depreciate relative to apple, and a pen will then be traded for fewer apples (consequently, market clears). There can never be excess supply nor excess demand in this model of economy because otherwise it is logically incoherent. Everyone is both producer and consumer. You work to produce something so you can purchase something else. Apple producers have to either consume or sell their output; otherwise, there is no point in producing apple at all. Even if they decide to save apple, it has to later be traded for pen, and saving should never be regarded as excess supply in the first place since the portion saved is not intended for sale. In such an economy, the market clears no matter what, and excess production is not possible. This alone also refutes the idea that immigrants cause shortage in demand because immigrants also demand necessities and amenities of life and the only way to satisfy their needs and wants is to supply their labour to the market in exchange for goods and services. Labour displacing technology, in the same manner, balance out demand and supply. Yes, there will be layoff, but at macro level, the laid off workers are freed up resources that ultimately (with friction) get absorbed into other sectors in response to the change in wage and rental rate (which depends on resource mobility and on average level of productivity of labour and capital). Such is the beauty of creative destructive force of capitalism. Economics is amoral (not immoral) in this sense, but that does not mean we should not care about human dignity and not impose moral constraint on the system. This sort of discussion, however, deserves a place of its own.

Yet, we have recession. What did we miss in that stripped down storyline? Was Say’s law false all along? The answer is “not really” because the apple-pen scenario we were imagining was in essence a barter economy (marked by the absence of money, or more broadly, medium of exchange).

Which brings us to the idea propounded by Keynes in the early 20th century about what really caused recession. Keynes observed that recession is a pure monetary phenomenon. The demand shortage (or excess supply) theory is not false (indeed, we have recession because the theory holds), but failure to notice it as being an illusion leads many to devise destructive ideology and bad policies. And, neither is Say’s law an intellectual arrogance. To illustrate, we need to extend our previous example to include money (fiat money), and then, we have to think of money as a product that has its own market. That is to say, there is demand for money just as there is demand for pen and apple, basically what Keynes calls “liquidity preference”. Only under this circumstance, can there be excess supply of products that lead to economic recession. Think about it. Money has three functions: (1) unit of measurement, (2) medium of exchange, and (3) store of value. The last two are particular central to the understanding of recession. But, under our previous oversimplified example on Say’s law, we completely exclude money. Even well beyond the tiny world depicted in our apple-pen scenario, we tend to implicitly treat money as only a medium of exchange, that money only exists as a lubricant for economic transaction. In that sense, money has no intrinsic value (i.e. there is no real demand for money). And that is precisely the wrong way to conceptualize the current economic system. To an extent, there is real demand for money for various reasons (as emergency fund, for peace of mind, for kids’ allowance, for small purchases, etc). Whatever the case, you should not expect to have $100 million in circulation just because that is the exact amount the central bank prints out. Of course, whatever is missing from the circulation goes partly into bank reserve, but is also partly kept under people’s pillows due to their demand for cash on hand. In order to satisfy such demand, this is why central banks usually print a bit more money than the targeted quantity.

All these seem fine and dandy, but what happens when liquidity preference rises inordinately? Reconsider the apple-pen scenario. Let’s say that this time the central bank prints $200 in cash and inject it into the system. Initially, apple and pen producers are endowed $100 each. Each wants to keep $20 on hand as emergency fund. Apple producers make 10 apples and sell them to the pen producers who produce 10 pens. It is not hard to see that the exchange price for every unit of both apple and pen at this point is $8 (since everyone has $80 left in hand and each has 10 units of their produce for trade). Let’s suppose that then there is rumour about the imminent economic slump due to the rise of Donald Trump. This prompts a self-defeating action by both producers (or consumers of each other’s product). Expecting crisis closing in, both pen and apple producers will want to supply more but demand as little as possible to save for the coming rainy days. The thing is, without money as in the prior example, there is no store of value, so exchange can only happen when a product is traded for another or for a service. In that manner, the act of saving for the future is possible only by saving your own produce, or buying others’ products and store them. As discussed, this generates no slack in the economy.

With money, unfortunately, people can postpone their purchase to the future. Say, pen producers at first sell 10 pens to apple producers at $8 and receive $80 in revenue. Under normal circumstance, this $80 is returned to apple producers in the form of purchase of 10 apples. But, fearing trump’s erratic economic policies, pen producers are now willing to purchase only 5 apples back so to keep more money on hand. Then in this economy, there is an excess supply of 5 apples. Usually, the ideal mechanism allows apple’s price to drop to close the gap, but since wages and rental cost of capital do not immediately react (dubbed “sticky wage“) and since market needs time to effectively adjust, we end up with the same price but less quantity of purchase (quantity demanded) instead. This is why the producers usually resort to laying off workers to cut back production (hence, the increase in unemployment rate during recession). Then, for the sake of discussion, let’s assume there is another product, pine-apple, in the market. This time, apple producers with less revenue also demand more cash on hand, and subsequently buy less pine-apple. Pine-apple producers receive the signal, and you can imagine how the rest of the story goes. Everyone is willing to sell but no one is willing to buy because in-between the exchange of all goods and services, there is money that makes holding off purchase (thus, not utilizing economic value at one’s disposal) possible. Tangible money can be stored in your own house, under your own pillow. When liquidity preference goes up, less is consumed and more is supplied leading to people cutting back production. Later, this simply means the relative value of money goes up and the price of everything else goes down. It results in downward pressure on price of all goods and services (i.e. deflation). However, because the real demand for cash increases, but not for products and services, the lower price only prompt people form rational expectation that future price would continue to fall and this further increases the desire to save and reduce production. This implies that during recession, barring price movement will not do much to improve the situation unless the government is consistent in its commitment and precedent has been established. Consistency will reshape people’s anticipation of crises, and this will change the economic dynamics of recession. An interesting inference at this point is that this very idea of consistent discretionary policy during economic crisis is probably what makes democratic system a bit less effective in dealing with crises since every new government has its own approach to crisis intervention.

“Wait a sec…” you say. Is saving not a good thing for the future? After all, saving can be channelled towards investment. If this is your argument, then you are on the right track. Indeed, saving is not inherently bad because people usually deposit their money in banks. Banks then provide loanable fund for investment. Saving, under this state of the world, is thus good for the future. Here’s the catch though. When liquidity preference rises abruptly and excessively for all players (when banks and investors also fear the imminent economic doom causing them to be insolvent), even banks will want to hold more cash in reserve. Investment will halt because investors as well are afraid of systematic error (since systematic risk cannot be diversified). Think about the 2008 financial crisis. Illiquid assets fell in price, so dramatic that even banks were unwilling to loan or invest in any assets (when assets fall sharply in price, panic permeates, collateral becomes useless, and investment would require a very huge return to compensate for the greater risk). This is when the economic engine stalls because everyone are stocking up their individual inventory (and not the commonly accessible inventory) with money. Banks begin to behave just like ordinary folks (after all, they are run by the people), and their function as financial intermediary freezes up. Again, people want to sell but no one wants to buy because money makes it possible to defer your purchase to the future. The end result is devastating. Demand falls and since price and wage are sticky in short-term, unemployment rises. With high unemployment level, demand drops further. Commodity price plummets and people start saving more in expectation of further slump. Distrust in banking system is pervasive, and everyone gets paranoid about spending. Since businesses run on liability (credit) as much as it runs on equity, narrowing access to credit and poor sales will cause them to start cutting down investment, and in an extreme case, goes bankrupt. Everyone needs refinance and everyone needs to sell off their imploding assets. This further lowers asset price. The velocity of money decreases and credit dries up. This is what economists call “credit crunch”. So, at the start, just because of the rise in liquidity preference (demand for cash on hand) and the loss of confidence in non-liquid assets, people sell more to get as much money but avoid spending to prevent losing too much money. A general glut occurs, and it all culminates in recession. Worse comes to worst, it morphs into depression just like in the 1930s.

So far, the known solution is for the central bank to perform open-market operation (i.e. buy bonds to inject cash into the system), a.k.a “Expansionary Monetary Policy”. However, there is a point when such a move is no longer potent because interest rates hit the all-time low 0% (i.e., “liquidity trap“). In this particular scenario, the only option left seems to be government spending. Any action that creates transaction (monetary circulation) will help restoring confidence and subsequently economic health. On a side note, as evil and heartless as it may sound, this is how World War II eradicated the severe economic depression of the early 20th century, all because war forces the government to spend (thus, effectively forces money to recirculate) and restore the economic activity. *If you are interested in this topic, visit the links below and do google to learn more*

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I include both the proponent and opponent of the idea that WWII got rid of depression. It is thus up to your judgment which side to take (or not taking side at all).

1. “How did world war II end the great depression? by Louis Hyman (Bloomberg)

2. “The great depression was ended by the end of world war II, not the start of itby Peter Ferrara (Forbes)

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The bottom line is that recession is always and everywhere a monetary phenomenon. People tend to, however, get it mixed up with the goods and services side of the economy so much that they neglect completely keynes’s wisdom. To be fair, some are not even aware of the monetary effect that causes recession in the first place. The problem with such ignorance, especially when it comes to policy makers, is that it causes them to implement unnecessary monetary and fiscal policies even when liquidity preference is at a healthy state. This only serves to precipitate unforeseen crises and causing unneeded inefficiency within our economic system. Understanding the symptom is thus indispensable in providing effective remedy to all social and economic ills. I hope the article is successful in fulfilling its intended purpose, to raise awareness about recession. Wherever there is confusion or ambiguity, feel free to send me an email via: info@economind.org.

Until next time,

Economind