The Most Important Economic Question: What Causes Major Economic Downturns
I don't think it's much hyperbole to call this the most important economic question that needs to be answered. Many have tried to answer the alternative question: How Do We Fix a Downturn? Unfortunately, this is often separated from the question posed in the title of this blog. That leads you to the obvious problem: how can you fix a problem when you don't know the cause?
Of course, there are reasons given for major economic downturns, and we'll investigate those in this blog. But what you'll see (I hope) is that there isn't very much teeth behind them. It is far more common for those in power to want to get things fixed than to figure out what broke in the first place. That's the nature of government. Detailed study and diagnosis doesn't win votes. The common man wants a "person of action" in charge. It seems to be so even when the common man is convinced those actors are complete blithering idiots (re: approval ratings). In other words, the common man tends to be quite confused about the nature of government, as well as economic law. The reasons for this are not for this blog, but I believe it safe to conclude this is the case.
I'm going to frame this question in a certain way, which I think helps us understand the problem more clearly. If you disagree with the way it's framed, let's discuss it below. (I want discussion here. I will be open to all opinions. Honestly =D).
If the market rewards entrepreneurs and business leaders with greater capital and greater responsibilty, how can it be that at certain periods of time, so many of them fail at once?
In other words, the reason entrepreneurs gain in wealth is because they provide value beyond the value of the capital used in production. They employ capital, earn returns when that capital is employed in accordance with consumer desires, giving them more capital at their disposal.
No entrepreneur is safe from the loss of capital. No industry is safe from the changes in consumer preferences or the introduction of new technology and processes from a competing entrepreneur. Businesses fail. That's the sign of a healthy economy. Industries become marginalized and sometimes, outright obselete. We don't mourn the loss of the horse carriage industry.
But these events are different than the major economic downturn. These explanations do not satisfy the question asked. Why would entrepreneurs across several industries suddenly all fail at once? That is not healthy market activity.
One simpleton explanation is that entrepreneurs are just lucky. It was luck in the first place that got them wealth and as such it is no surprise when their luck runs out. Besides failing to explain the cluster of errors, this common explanation (often advanced by supposedly non-simpleton academicians) doesn't stand up to scrutiny.
While not denying the role of luck in human affairs, I must question why entrepreneurial luck would not run 50/50 over a long enough time frame. Why is there more good luck than bad luck? The market economy advances in the long run, indicating that capital is used to provide value more often that it is not. Why wouldn't the long run trend be to half-effective capital and half-ineffecitve capital? That would be more indicative of luck being behind the success of entrepreneurship. I have to dismiss the idea that luck is the primary cause of economic success. It is, at best, a secondary cause.
Defining the Downturn
There is even a problem with defining the downturn. There is no non-arbitrary way to empirically define a depression. A line in the sand is drawn. The word depression itself is a relatively new term. Previously, major downturns were known as panics. The very word panic indicated that the effect was temporary and normal economic activity would soon be restored.
And that brings us to an interesting historical point: what changed that panics became depressions? We'll come back to this.
For now, we will accept the standard econometric definition of a recession (the NBER does not separately define recessions and depressions, even though it would be just another arbitrary line).
"We refer to the period between a peak and a trough as a contraction or a recession, and the period between the trough and the peak as an expansion. " - NBER (http://www.nber.org/cycles/recessions_faq.html)
Are there any problems with the way the NEBR defines peaks and troughs? That's something we will address later. It'll just sidetrack me.
ECONOMIST'S ANSWERS FOR THE MOST IMPORTANT QUESTION
When the housing bubble collapsed, it was plain for everyone to see that too many houses had been built. In a nutshell, this is why the theory of overproduction is so attractive. The capitalist system produces too much in good times, outrunning consumer desires.
But this is a chicken-egg argument. Are capitalists producing too much because business is booming, or is business booming because of the tremendous amount of production? I say, who cares, since there is a better way to look at this.
We know that the purpose of production is to increase the value of capital, by producing goods of higher value than the value of the goods used in production. However, this could only lead to overproduction if the desires of consumers had been completely saturated. That's not the case. (Nor does it appear it ever will be.) Instead, the case is one of a mismatch between production and demand. There is still wants unfulfilled, but prospective buyers are not satisfied with this distribution of goods at this price.
Understood in this manner- that we are not in the Garden of Eden where everyone is completely satisfied- now the problem is no longer overproduction but one of price. Either entrepreneurs will speculate on higher prices down the road, thereby sitting on inventory, or they will lower their prices.
"Deflation! Run for the hills!" - says the mainstream economist.
We'll tackle deflation and depressions at another time. It's a phobia. Many economists have it - despite zero scientific evidence that deflations and depressions are linked. (Yes, yes, I know you were told there is, but there is none. Not even empirical evidence.)
The problem isn't overproduction. It's a pricing problem caused by a cluster of errors. In other words, the theory of overproduction doesn't actually help us understand what causes major downturns at all. It's a rationalization for what one sees after a downturn has occured, and an incorrect one at that.
In kind of a Marxist twist on the theory of overproduction, the theory of underconsumption points to a mal-distribution of wealth that arises when capitalists get rich at other's expense until those "others" can no longer buy the goods produced by the capitalists. It's a slack of consumer demand. There is some of this idea in Keynes' General Theory as well.
But this theory doesn't help us understand the cluster of errors either. Remember, we have accepted that entrepreneurs are in their position (and maintain and increase that position) because they successfully match production to consumer demand. It's not all luck. So why would they suddenly fail to produce goods that people cannot/will not consume all at once? In other words, the theory of underconsumption simply rewords the question and doesn't answer it.
In a market economy, the value of producer goods is determined by the value of the goods created in production. In other words, the demand for computers determines the value of all goods used to make computers (along with every other final stage and intermediate stage good used from those productive factors). Value is imputed back from the consumer good to the higher order stage good.
So if the value of the consumer goods are falling because of a mal-distribution of wealth, then the capitalists employing factors of production will see a fall in their wealth as well.
However, the role of the entrepreneur is to successfully forecast such shifts in consumer demand. That's how he/she got their in the first place! So we still haven't explained why so many of them cannot forecast such a massive shift all at once.
You see, we are no closer to the answer. An offshoot of the underconsumption theory is the acceleration principle, but it's so ridiculous and naive I will not waste your time with it.
Too few investment opportunities
This theory is popular with economists who fail to understand that investment opportunities are limited only by consumer desires. And since, there is no limit to those, the theory falls apart rather quickly. Some economists, more savvy than others, point out that in a competitive environment, the rate of profit will tend to decrease naturally. Hence, at some point, they will reach zero. As they approach zero the lack of investment opportunities causes a general downturn. Some blame it on population growth. Others play the Peak "insert natural resource here" Card.
It's true that in a competitive economy the rate of profit tends to decline. And it would approach zero if the economy stayed exactly as it is without any innovation, changes in time preference, or new natural resources are are discovered.
Those are big IFs, particularly the first two. The third has played an important role in the past (and to some extent, still does more than the casual observer thinks.)
I don't find this view very appealing. I can't imagine a time in the future when investors and entrepreneurs would run out of ideas for new opportunities all at once. It certainly has never happened in the past. The one truth of economic life is constant change. Change creates opportunity, even in the biggest booms.
One of the most interesting, yet ultimately flawed theories is Schumpeter's Creative Destruction. Schumpeter reworked this theory throughout his life so it's often misrepresented or only partially understood. His main argument was that innovation was financed by credit expansion. That's notable because he's one of the few economists who admits the link between the boom and credit.
However, Schumpeter failed to explain why credit financing would be focused so heavily on new innovation, rather than increasing known processes. Schumpeter doesn't seem to understand the full scope of entrepreneurial activities. To him, they are simply inventing new ways of production. But that is only a small piece of the role. And that's where this theory really falls short. We know that a very important aspect of preserving and increasing capital is the proper adjustment to supply and demand conditions. Since Schumpeter ignores this part of the economic world, he doesn't have to answer the BIG QUESTION: why did owners of firms, both old and new, both innovative and conservative, make so many errors at once in their forecast of economic conditions?!
Instead, Schumpeter focuses on the technological innovation solely, leading him to believe that a cluster of innovations is the problem, rather than a cluster of errors.
Even if we did accept at face value Schumpeter's reasoning, we would have to ask the next logical question: why did so many incorrectly forecast the success of their technological breakthroughs on their profit margin?
Again, we are no closer to the answer.
Qualitative Credit Doctrine
I kind of like this one, personally, and I think it has some value. According to this, it's the mismatch between maturity and quality of credit issued with that taken. In other words, the banking sector expands in say, poor quality mortagage loans. People who lay the blame for this recent housing bubble on the CRA, Fannie Mae, and Freddie Mac, often unknowingly are taking the qualitative credit doctrine that was proposed by the Banking School (now defunct).
The only real problem with this idea is that it doesn't address where the money comes from to make such loans and more imporantatly, how such practices can persist for so long without market forces reigning it in (via redemption, for example) to generate a boom. Certainly under a Federal Reserve system with an unlimited money trough, qualitative distortions can persist for a long time, creating boom conditions. However, that means the primary culprit is not the lending institutions per say, but the institutions set up to prevent market forces from performing corrections as needed.
So while this theory does find many adherents among the proponents of sound money and laissez faire, it is only a proxy issue when dealing with the big question and cannot be the primary cause.
The major theories surveyed here do not bring us closer to answer the big question. If we don't have an answer, how can we expect to implement policy that will fix the problem for which the cause is unknown.
I left some arguments off this list, so feel free to add them in the comments section below.
Many of you know that I feel the Austrian School's Business Cycle Theory is the most explanatory, as it deals with the alteration of the structure of production, something other theories do not touch. But I have covered that at length in other blogs so I won't rehash it here.
If you do have a criticism of that theory, I would like to read it.
David in Liberty
(in debt to Murray Rothbard for his fine coverage of business cycle theory in America's Great Depression)