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A Quick Guide To Recessions

Dan Tortorice

We are about to experience the United States in a recession. Most readers of this article have never really experienced an American recession, since during the last one in 1991, most of us were too young to notice.

Since this is the first recession we will really live through, it may be a bit scary. But not to worry, recessions are temporary matters and soon we will be looking back on this one.

There are two ways of thinking about how the economy generates output. The first is the black-box way. The economy has resources, machines, people, land etc., and you put those resources in a box and out pops a bunch of goods and services. This view of the economy doesn’t allow for recessions. If you put the same amount of things into the box you should get the same amount out. In order to understand recessions, one must look at the economy in a second way, and realize that sometimes consumers won’t want everything that comes out of the box. When this happens, businesses produce less, and they put less stuff into the box. When there are fewer people put in the box, we have more unemployment. And when they put less stuff in the box, less comes out, and we have less output. That’s a recession.

Originally, economists didn’t believe that this could happen. They argued that in making the stuff that went into the box, enough income had to be generated to buy what came out of the box. This idea, called Say’s Law, implied that recessions did not happen. Say’s Law died with the Great Depression when John Maynard Keynes, the founder of macroeconomics, pointed out that there is no reason that consumers will want what comes out of the box. The only way to get them to want to buy it is if prices decrease to the point that consumer demand rises again. But he noted, and many empirical studies have confirmed, that for whatever reason, prices are slow to adjust. Until prices adjust, some of what could come out of the box, won’t, because people just don’t want to consume it. This is the first cause of a recession, a shortfall in consumption.

There’s a second cause, which is similar, but worth considering separately because it deals with businesses. Businesses invest a lot, and that contributes to output. But these decisions are made on expectations. A consulting firm invests in computers, hoping that they will improve its business and make money in the future. What happens when those expectations do not pan out? Firms are stuck with too much investment, they have too many computers and machines, and these firms no longer want to invest. In other words, there is a shortfall in business investment demand. This is the second cause of a recession. And the coming recession will be caused by a combination of this and the previous reason.

The nice thing about knowing the cause of something is that one can then find a cure. And there are three specific cures that will help lift the United States out of recession. This is why I can confidently say we will be looking back on the recession soon enough.

The first cure is for the government to print money. Make more dollars and put them into the economy. This may seem strange, after all. If you just doubled the amount of money in the economy overnight, shouldn’t things just become twice as expensive and shouldn’t everything go back to normal? The answer is yes, eventually. Remember that it takes a bit of time for prices to adjust; this means that the government can create income in the short term by printing money. When people have more money, they spend more. When people spend more, businesses want to make more come out of the black box. So resources are put back into the box, generating more income, which sustains the increased demand, getting the economy back on its way.

To cure the lack of business investment the government can reduce interest rates. This happens as a consequence of printing money. When the government increases the amount of money in the economy, people’s behavior needs to be modified in order for these people to want to spend that money and not save it. For that to happen, it must become less valuable to save; that is to say, the interest rate on your savings must fall. When that happens, banks charge less for loans, businesses can invest more cheaply, and they begin to invest more. In investing, these businesses begin to employ some of these unused resources and the economy gets going again.

The last thing the government can do is to force people to spend. Not by use of force, per se, but by taxing them, taking their money, and then spending on public works projects, transfers to the disadvantaged, and the like. This will get resources going again, and get our economy back on track. So if you are worried about the coming recession, don’t be. Our government has the tools to fix it, and seems to be using them. It’ll be tough, but soon our economy will be growing again.