Friday, January 20, 2012

Why Recessions Happen

Most commentators in the media seem to imagine that recessions can be avoided. The former British Prime Minister Gordon Brown even turned this delusion into a political slogan: “No more boom and bust”. Of course, particular recessions have particular proximate causes. The subprime crisis was the catalyst that kicked off the great recession we still have not quite got behind us. But that was not why it happened. After all, the sovereign defaults and the LTCM collapse in 1998 didn’t cause a recession. Nor did the dotcom crash of the early noughties. So you need to look a bit deeper to understand why recessions happen and why they cannot be avoided.

Here’s my theory (which I very much doubt has the merit of originality). I call it the theory of crud. Actually, I don’t. But the word I use instead of crud isn’t appropriate for a family blog.

When economies are growing, we can get away with quite a lot. If you have an underperforming employee, then firing them is probably more trouble than it is worth if your business is still making lots of money. Innovation is risky and there is little point in it if you can make money doing what you’ve always done. This is human nature.

Economic growth will also resist measures that might be expected to stifle it. Government regulation and taxation, as well as high debt levels, are cases in point. A growing economy allows us to feel we can take on more debt than is prudent. It encourages governments to increase public spending to look after their clients and stay in power. So they raise taxes, so removing money from productive uses in the private sector to unproductive ones in the public sector. Governments also get themselves into debt more than they can afford. Growing economies let them (and us) get away with mortgaging the future.

Over-regulation is even worse. It is essentially a form of taxation whereby money is moved from productive sources into the hands of compliance officers and inspectors who are often, but not always, in the public sector. But regulation is also less obvious and can be disguised as a good thing when it purports to improve health and safety; or the environment or whatever. This makes getting rid of red tape an enormous challenge. When an economy is growing, no one can be bothered. Protectionist policies are the same. Free trade is a hard sell.

And it gets worse. A growing economy lets people make colossal and stupid mistakes without being punished. Utterly insane ideas, like joining Europe’s disparate economies into a single currency or giving up fossil fuels, can appear to be working when the damage they do is hidden under economic growth.

Crud is what I call all this taxation, petty rules, overhanging credit and stupidity. It jams the works of the economy like sand in a machine, wearing down the gears and gradually making the whole mechanism less efficient. But when the wheels are turning, they can overcome this resistance. The crud continues to build up, week by week, but while the machine works, it is worth nobody’s while to do the hard work of clearing it out. Things are obviously much less efficient than they should be, but they still work enough for people to pretend everything is fine.

But eventually, the crud has built up to such a level that it causes serious damage. Important works clog up. Gearwheels crack under the strain of turning through the rubbish around them. The machine judders to a halt. A recession begins. Exactly where and when this happens is essentially random. But a time comes when an economy is simply not functioning well enough to overcome a shock. Only then does the clear-up begin.

That’s what makes recessions so painful. All those decisions that were put off when times were good can no longer be avoided. The shirking employees have to go; the debt must be repaid. Idiocies like the Euro show their true colours. The engine of the economy has to be steam-cleaned at vast expense and discomfort. By the way, the recession we have just had was so deep and prolonged not because of wicked bankers. It was just that long boom from 1990 to 2008 gave us so many opportunities to accumulate crud. Getting things going with so much junk in the system is extra-hard.

And there is an added danger. The recession can lead people to demand even more regulation and red tape in the ignorant belief that this prevents rather than causes economic reverses. Keynesians cry that we have to shovel even more crud into the system to get it going again. Roosevelt’s famous New Deal is now known to have made the depression of the 1930s even worse than it needed to be. And here’s why: the New Deal just showered crud over everyone. Sadly, the only way to get the economy moving again is paying down the debt, tearing up the regulations, slimming down the workforce and keeping markets open for business.

So, in summary, we get recessions because capitalism works. Capitalism generates economic growth. When things are good, human beings have a natural tendency to avert their eyes from future problems. But eventually we just have to roll up our sleeves up and carry out the necessary spring cleaning. The very worst thing we can do is pile up more debt, bring out new rules, raise taxes even higher and erect trade barriers.

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7 comments:

Fake Herzog said...

Actually, the economy did experience a recession beginning in March of 2001:

http://en.wikipedia.org/wiki/Early_2000s_recession

By the way, I love your blog. Keep up the good work.

P.S. Your theory of recessions sounds very Austrian -- they like to talk about malinvestments, which is sort of like your idea of "crud", although they focus more on private-sector debt, rather than public-sector debt.

spandrell said...

The Austrian theory of the business cycle explained in plain language. Very good work.

Economics should be a branch of sociology, not a political scam using graphs and equations.

James said...

Austrian? My friend Daniel Hannan is a fan of Austrian economics so I'm glad I'm echoing his views.

We didn't get an early 2000s recession here in the UK. That Wiki article reminded me of the doomsters who can predict eight of the last four downturns.

spandrell said...

Austrians call it "malinvestment", and they use complex mathematical models referring to interest rates and all that.
But what you're saying is pretty much the same thing. Incentives get set in a way that makes it hard to change anything, because hey things are going well, don't spoil the fun. Eventually the money invested doesn't give returns, and people go down.

Fake Herzog said...

"We didn't get an early 2000s recession here in the UK. "

I'm so provincial -- I just assume everyone writing in English lives in the U.S. until told otherwise ;-)

Eckadimmock said...

Some countries have avoided the cycle - by opting for perpetual bust.

ndrosen said...

This an interesting idea about recessions, and partly true, IMHO, but it neglects another part of the truth: the real estate cycle. Prosperity produces higher land rents, which lead to much higher land prices, because the selling prices capitalize expected future increases in land rents.

The boom continues, because land looks like a good investment for speculators, and even if you don't want to speculate, you may figure that you need to buy a lot now if you're ever going to afford a home of your own, because prices are just going to get higher.

However, land prices (often referred to as "real estate" prices, or even "housing" prices) cannot outpace GNP and wages forever, and when somehting truly can't go on, sooner or later it doesn't. Prices stop climbing, and because they are based on the expectation of further increases, rather than on value for current use, they are not stable. They don't just stop increasing; they fall.

Then people can't or won't pay their mortgages, CDO's based on mortgages become less valuable than the computer models predicted, defaults touch off defaults, and the contagion spreads.

That's the main cause of depressions and unemployment; the basic idea is due to Henry George in the 19th century, and has been refined by Professor Mason Gaffney. Dr. Fred Foldvary went on record predicting the 2007-2008 crash sevral years in advance, based on his Austrian-Georgist synthesis. I recommend further study of Georgism and land value taxation.