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Dealing with Recession

Tags Business CyclesMonetary Theory

01/31/2008Clifford F. Thies

An old joke is that economists have called 19 of the last 16 recessions. Our signal of a recession is three months running of decline in the index of leading indicators. We have not yet had a recession without first having the signal. But, we have occasionally had the signal without the subsequent recession. Well, on January 18th, the Conference Board released its economic indicators and, with this release, we got the signal of the now long-awaited recession. What does it mean?

First, it does not mean we will have a recession. It means we will probably have a recession. We might wind up with a mere slowing down of the economy and avoid an actual recession.

Second, it does not mean we will have a deep or long recession. How short or long, and how shallow or deep is the recession, if we have one, cannot be forecast. Your guess would be as good as mine.

Third, and this is the important point, we economists can now stop trying to explain to people that we actually are in a well-functioning economy, and can start to commiserate with them about how bad things are. If there's one thing hypochondriacs don't want to hear, it's that their many serious illnesses are all in their heads.

Before, we would respond to complaints about the global economy taking away jobs by saying a 4 percent unemployment rate means we have roughly full employment. Now, we can say, while 5 or 6 percent unemployment is a low level of unemployment by historical standards, its recent uptick is indicative of a slowing down of an economy and possibly of the start of a recession.

Hopefully, the listener will be assuaged by the sympathetic response, and not ask if there is a connection between the global economy and the recession, because we would have to explain that, because of the recent surge in exports, the recessionary pressure that has developed has been ameliorated by the global economy.

Instead of responding to complaints about the high rate of inflation by saying a 2 percent rate of inflation is pretty close to price stability, we can now say that a rate of inflation of 3 or 4 percent, which has been accelerating recently, is indeed a cause for concern.

For all the talk by the Federal Reserve about "inflation targeting," we now see that responding to short-run problems is paramount for the Fed. Holding the line on inflation is something the Fed does when it is convenient. Resorting to inflating the money supply when times are tough is predictable, as is a continuing loss of purchasing power of the US dollar. The only uncertainty is how fast the dollar will lose purchasing power. Will it be at a creeping rate, or at a galloping rate, or at a hyperinflationary rate?

You might think that we learned our lesson about inflation during the 1970s, when we moved first from a creeping to a galloping rate, and then risked a further move to hyperinflation. The double-dip recession we then went through starting in 1979 fell in the second tier of economic downturns (below only the Great Depression). There is currently no indication that a severe downturn is on the horizon. But, if we work hard enough at it, with fiscal and monetary policy pumping up the economy and delaying and exacerbating the inevitable, we can make such a severe recession possible in the future.

This brings me to the Austrian approach to the business cycle and the suddenly revived Keynesian approach embraced by the Federal Reserve, the Bush Administration, the Congress, and the popular media. The Austrian approach would call for the quick and even ruthless liquidation of the malinvestments that were made during the misguided prior boom in the economy. In contrast, the Keynesian approach talks in terms of aggregates without differentiating one type of investment from another, as though the spending of tax rebate checks will have a meaningful impact on the particular sectors of the economy that are in trouble.

In the Austrian view, many business cycles are manifestations of interconnected periods of boom and bust. The boom occurs when the normally prudent risk taking of businesspeople is replaced by overoptimism, and is financed by the creation of credit. A central bank isn't even necessary for this to happen, as private banks are perfectly capable of creating credit on their own, through relaxed standards of creditworthiness. However, now that central banks are around, we can suspect that they aid and abet the process of credit creation, which distorts signals to investors, since the created credit does not reflect decisions by households to save. To revive some antiquated terminology, the created credit is a form of "forced savings," and embeds a disequilibrium into the economy that will eventually reveal itself.

Among the cycles of bank-financed booms and busts in our country's history have been the Canal Extravaganza of the early 19th century and the Railroad Extravaganza of the late 19th century. More recently, we had the dot-com boom of the 1990s and the real estate boom of this decade.

I would say that in many of the booms of these cycles, there was something good at the beginning, and the market simply got ahead of itself thinking that nirvana had been achieved. Caution came to be replaced by euphoria and greed, allowing not only an overinvestment in what was initially a good thing, but also allowing the entry of a variety of con artists and even some outright crooks.

The unwinding of the positions taken during the boom is never very simple, because once capital is invested it loses its initial fungible quality. Initially, capital might be invested in this industry or in that. But, once invested, it usually cannot be easily recovered for reinvestment in a manner better aligned with consumer demands. After the collapse of the dot-com boom, it was not economically possible for companies to recover their investments in hardware and software, and it would have been silly for highly trained programmers to try to become welders or health professionals, honorable as all of these occupations are. Instead, the companies and the people had to make the best of their situations until real growth in the economy, and the normal course of depreciation, obsolescence and retirement restored a balance between supply and demand for the industry.

It is similar today, with the malinvestment in upscale, single family homes in many real estate markets. As long as we don't do anything really stupid, we can expect that over the next few years, our economy will grow enough to absorb the present glut in most of these markets.

But, you can never really discard the possibility that we (meaning, the government) will do one or more really bone-headed things. Some really bone-headed things that come immediately to mind are: cracking down on mortgage bankers, raising taxes on the upper middle class, driving interest rates down as low as possible, flooding the markets with funny money, attacking the automobile, and deporting millions of people. Such things as these will further reduce the demand for upscale, middle family homes, depressing their values, and forestalling any recovery in the construction industry. Compared to those inane responses, sending out tax rebate checks sounds benign.

Just as overoptimism and greed come into the booms of the Austrian business cycle, excessive pessimism and fear come into the busts. A free society requires confidence, as well as business entrepreneurship. Fear is antithetical and often comes in the vanguard of some form of authoritarianism. Thus, what is much more important than tax rebate checks is a sound economy that evinces in people confidence that we can and will work through difficult times.

In the meanwhile, it is a good time for everybody to reconsider his or her own financial situation. Are you, for example, basing your retirement security on "safe" bank deposits and bonds denominated in US dollars, thinking that inflation is a thing of the past? Are you mortgaged to the hilt, maxed out on your credit cards, and otherwise conducting your business as though we will never again have a recession? When used with discretion, debt can be a good thing. But many of us individually, and we as a society, can have too much of a good thing.


Contact Clifford F. Thies

Clifford F. Thies is the Eldon R. Lindsay Chair of Free Enterprise at Shenandoah University in Winchester, Virginia.

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