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Do Falling Prices Cause or Predict a Recession?

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Tags Booms and BustsInflationBusiness Cycles

In the midst of excessive US economic and geopolitical uncertainties due to rampant inflation and the continuing Russian invasion of Ukraine, the 7.7 percent October inflation report comes as a small relief. The unemployment rate touched 3.7 percent in October, remaining near the 3.5 percent prepandemic level and slightly above the 3.4 percent natural rate of unemployment of the fourth quarter of 2021.

The Covid Inflation

The general increase in price levels, most monetary economists believe, comes directly from an increase in money supply through a rise in the rate of nominal spending (nominal gross domestic product [NGDP]) above the nominal trend required for full employment or potential GDP. Above that nominal trend, the economy becomes “overheated,” and prices in general are inflated. While this understanding of the effects of nominal spending above its trend level is indeed correct, neglecting how such increases arise and continue tends to miss significant effects arising from the real, productive side of the economy that have facilitated US inflation since early 2021. 

Any increase in nominal GDP growth above the trend rate of growth is inflationary in the sense that productive agents in the economy are competing for relatively scarce resources. But this growth in nominal spending, which leads to higher prices, also inflates the profit margins of firms, thereby creating profitable opportunities.

Higher profit margins prompt firms to expand their output by increasing their capacity utilization. At the same time, rising profits lead to a reallocation of capital from lower-profit industries to those that have experienced this profit-margin growth. When discovered by entrepreneurs, these profit opportunities result in the expansion of the economy’s output capacity through capital investments.

These supply increases give rise to counterbalancing downward price pressure. Firms competing for the same customer offer lower prices, and this fall in scarcity relative to demand stops the rise in prices and may even cause falling prices.

A onetime increased nominal growth in spending can initiate the equilibration process by increasing the supply of goods. But such a reallocation process requires a period of high prices in which the same resources that were being used in the production of final consumer goods can be freed up and allocated toward the production of capital and investment goods. This would increase the economy’s production capacity and mitigate the rise in demand.

The increase in productivity developed to handle high demand increases the potential GDP (or the total means demanded by individuals) and subsequently the trend rate of nominal spending required to achieve a stable price level.

This price equilibration process is an interactive process where manufacturers’ higher prices are accepted and paid by consumers. However, if the rise in prices is not a onetime phenomenon but persists, it is because the growth of supply is lower than the growth of demand for goods in real time, which does not allow the market to rebalance. If demand doesn’t fall in response to high prices, typically consumers pay for goods using accumulated savings or by borrowing. This does seem to have occurred in the US economy, where both the absolute amount saved and the savings rate have been falling since the start of 2021.

But the fall in savings (or lack of them) soon leads people to reduce spending on nonessential goods as real incomes continue to fall and high prices persist. This subsequently causes a drop in demand for nonessential consumer goods, causing a reduction in the output of those goods. Businesses then demand less inputs, allowing for the correction period to begin.

However, we see that consumer debt (per the Federal Reserve) increased from 3.63 percent in December 2020 to a peak of 12.12 percent in March 2022 and declined to 7.8 percent in August 2022. The credit spending was in large part due to interest rates, which the Fed did not increase until March 2022. This credit spending ensured that prices did not fall (i.e., there were no deflationary price adjustments) due to decreased demand, whereas the generation and use of money to finance consumption (by encouraging consumers to draw down savings and increase credit spending) delayed the adjustment period actually required for supply to catch up with demand.

The Structure of Production and Scarcity-Induced Inflation

If consumption doesn’t fall and goods are purchased at higher prices, then a scarcity of specific inputs can occur. Since inputs are used in increasing output, scarcity prevents adequate investments toward handling excess demand.

Some of these specific goods are raw materials produced in the primary stage of production. Raw material produced through agriculture, forestry, fishing, mining, oil extraction, and other industries are created by processes that take more time and generate cyclical output flows. As these inputs form the base of almost every other product or service provided to consumers, fluctuations in their prices are a significant inflationary component in consumer goods prices.

When higher costs are financed by both an increase in credit and a drawing down of savings, inflation continues until there is a sufficient fall in spending to allow the market to reallocate resources. This adjustment can come in the form of a recession, in which a rise in unemployment leads to a fall in spending. A reduction in spending causes the drop in demand necessary to initiate the reallocation process.

Recession as a Necessary Adjustment Period

A recession with falling output and rising unemployment serves as the adjustment period during which businesses are separated into two categories: profitable investments in areas that can support higher prices based on consumer demand and unprofitable investments that previously seemed profitable solely due to unnaturally low interest rates and aggressive fiscal spending. The unprofitable enterprises either shut down or reduce operations during the adjustment period. Their workers are reallocated to businesses where they can be profitably employed based on consumer income and natural spending capacity.

Nominal gross domestic product (NGDP) targeting seeks to stabilize economic output, equated with nominal GDP, by pursuing a rate of growth consistent with the economy’s potential output. With today’s rising inflation, this means either raising interest rates or decreasing the money supply until spending is consistent with the Fed’s target. NGDP targeting would also subsequently lower interest rates during the coming recession to try to ensure that spending doesn’t collapse.

Pursuing such policies inevitably blinds one to the natural course of the real economy. The real economy relies on a heterogeneous capital structure, generates a steady output determined by genuine consumer choice, and leads to natural employment levels and prices. NGDP targeting shrinks the reallocation window and thus keeps the market unbalanced longer. 

Keeping interest rates lower than the interbank market rates and increasing the money supply inevitably lead to a false expansion in certain sectors, which, in turn, raises their employment and output. But such an expansion, not sustained by consumer choice and income, will need repeated monetary injections during a recession. This would mirror the way the economy was manipulated after the covid-19 recession, which has led to today’s high inflation and stagnating output.

Author:

Vibhu Vikramaditya

An economics and a libertarian scholar with research interests in capital theory, monetary theory, and business cycles, I write about events in the economy from a legal and economic standpoint with a proliberty outlook and believe that safeguarding the liberty and rights of each individual is the most important act toward peace, prosperity and growth. My other works can be found at the Austrian Economics Center, the Libertarian Institute, and beinglibetarian.com. I can be reached at Vibhu3333@gmail.com and on Twitter (@vibhu3333).

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