What’s a recession good for?

The Collectivist-Utopians (my new name for Progressives) lament the current economic environment as something that the government must ‘fix’, we must ‘do stimulus’ (a statement that only breathless policy wonks who haven’t had a real job in their lives can say) or we must prevent economic contractions at all costs. The Libertarians (me, for example) say leave it alone, you caused the problems in the first place. But really, what makes sense? I’m sure many of you are honestly trying to understand what’s what, but are overwhelmed.  Look, I’m just a regular guy, sort of smart and with some real world economic experience (market and credit risk management/capital markets). I’m not a great seer like the supposed geniuses babbling away 24/7 about the economy, but I do think I understand a few basic things that you might benefit from thinking about, so here goes.

A recession occurs when a simultaneous drop in demand in enough segments of our economy causes aggregate GDP to contract from previous levels. In a growing economy, there are always ups and downs in various segments, say steel sales fall, but software sales increase or resorts have a tough time but pharmaeceuticals have a banner year – you get the point. It’s the benefit of diversification. Countries that don’t have diverse economies are very risky, witness the boom/bust economies of oil producing nations, with little other industry. Okay, are you with me so far? So what happens in recession is that aggregate demand in one or many economic sectors is reduced so dramatically that other sectors can’t make up for it. That’s why some people still do well in a recession because their sector (sometimes a sector is just geographic or demographic) still has good demand characteristics. Health care would be one of those sectors in our country, for example.

Pretty simple, right? No need for oracles speaking theoretical mumbo-jumbo to understand that. Now, on to a longer view of this. Industrial sectors and the overall economy grow and contract over time, but our hope is that the overall economic pie gets bigger. Now this is where the magic comes in. Think about it, why does our overall economy get bigger? Well it could be inflation, population growth or our exports increasing, but let’s say we adjust for all the externalities and still find our economy growing, what causes that? Well, it’s productivity growth. What is productivity growth? It’s essentially increasing output without increasing capital or labor. Okay, you still with me? I promise, I’m trying to take you somewhere worth going.

How does this miraculous productivity growth occur? Innovation and efficiency improvements. We’re either able to produce more goods with the same cost or produce the same goods with less cost. This occurs in a free market economy continuously, and can be described by the following ideas:

1. Comparative advantage/specialization – This concept essentially observes that some producers are more productive producing a specific good than others in a given marketplace.

2. Mutually beneficial, free exchange of goods/property – In a free market, producers and buyers are  free to buy/sell from each other or not, pursuing their own interests, namely profit or other forms of self-interest.

3. Creative destruction – Given the above, the free market grinds away, continuously rewarding and punishing participants with either profit or loss. Inefficient producers are forced out and efficient producers grow. This machine runs all by itself, with a little lubrication from the rule of law and at least somewhat stable money, being the byproduct of zillions of little decisions that we all make every day, without the guidance of government, I might add (I have to get my Libertarian thought in there).

Okay, so what’s my point? Well the segments of our economy that are contracting perhaps need to in order to grow again someday. Without going into abstruse theories, let’s just summarize the problem by saying that the production in these sectors outstripped demand. Well how did that happen? In our case, there is ample evidence that both inflationary and loose credit policiea (one in the same in many ways) by our government essentially subsidized demand in a number of industries. What happens when these subsidies (and that’s what these policies are) are added to the equation? Well one outcome that’s certain is that the normal competitive pressures relax a bit, as both producers and buyers, buoyed by free cash, do some pretty stupid things. The buyers buy stuff they can’t afford, meaning they pay prices that otherwise wouldn’t be competitive and producers get excess profits. In our case the government encouraged this, but it couldn’t go on forever, and it didn’t. This is, essentially, the boom bust cycle of rigged monetary policy and government intervention.

Let’s look at this in the real estate sector. When, for example, the Feds implicitly guarantee Fannie Mae’s securities, allowing it to take risks which if it were owned by private interests would never be allowed. If at the same time the Feds don’t put any money aside to account for these risks (as in this case), essentially we’ve given free money to the real estate market. The real difficulty of this example is that the benefit is so widespread, it’s hard for any single interest to say no. Think about it, the homebuyer benefits, the real estate brokers benefit, construction benefits, the banks benefit, Fannie Mae benefits by growing and paying its execs millions and the politicians benefit by promising housing to people who couldn’t otherwise afford it, thereby gaining their political support. The only problems is it’s a Ponzi scheme, where the last few players at the table get left holding the bag, and then the whole system just stops. No more buyers because as a result of all the frenzied buying, the prices have been bid up to a level where even the most clever banker can’t make up a plausible excuse for how the buyer might ever pay back the mortgage. This is the demand side of the equation, and once it slows down, the entire system built to serve it collapses. As an aside, I’ve just read that the 400 billion that we’ve given to Fannie and Freddie isn’t enough to cover their losses – I wonder what would have happened if the Federal government had to set aside these reserves from current accounts back when they created these uneconomic incentives? Perhaps they would have had a hardrt time getting their destructive policies passed.

So, now what? Well, what should happen is that prices decline until new buyers are brought into the market. Real estate is just one example of this, you see it very clearly in business products/services all the time. Oversupply leads to falling prices until there are buyers. Along the way all the inefficient suppliers who gained excess profits from this bubble are forced out, and what little capital they have left is invested elsewhere. The labor in the space finds other gainful employment, in businesses that are growing by being more productive – hopefully not in another industry being pumped up artificially by government. The remaining players in the space are leaner, better producers and gain market share as the sector recovers, but increase the productivity of the space. Maybe technology plays a part. Look at web based sales tools for owner based listing in real estate. For a few hundred bucks you can list your house online with a virtual tour, cutting down the real estate commissions on a given transaction. Real estate brokers become less necessary and that’s one of a zillion ways that the market becomes more efficient. The same happens in construction, where perhaps the use of plastic plumbing or more energy efficient design is now rewarded by more cost conscious buyers, and so on. It’s brutal and painful, but left to itself, as long as the forces mentioned above are allowed to work, the sector comes out stronger and resumes growing. Free market economics fixes the problem, and Libertarians cheer!

The grown-up reality is that a recession is really just a bunch of sectors that have seen demand drop at the same time (whether via govt meddling or not, but it’s more likely if it is). The worst thing we can do is stop these sectors from righting themselves because that’s the only way that they can start growing again. When you hear government officials and politicians talk about ‘creating jobs’ and ‘growing the economy’ like it’s a garden in their backyard, remember what I’ve said here. It really isn’t that complicated – but it pays for them to have you think it is. That way they can continue to favor their pets, whether it’s the ‘ownership society’ or ethanol – the government only disrupts the functioning of the market in these sectors. They can’t create real demand where it doesn’t exist, rather they just disrupt markets even further, no matter how much money they dump from the skies – and oh yeah, that money is either borrowed money or money taken from someone else’s pocket which would have been used more efficiently if it hadn’t been confiscated.

One final word. I’m sure more academic readers of this article will skewer me for this simplistic exposition of ideas, because that’s what happens on the internet. Some guy who’s filled his head with arcane muck will dump pages of dreck on me that inevitably turn out to be nonsense (sadly it often takes me hours to get through their uniformly long and overly complex arguments). Don’t bother – this article isn’t for you. Keep up your Keynesian fantasies, or arcane socialist-mutualist or ‘luxury economy’ theories – I’ve already read it all and it’s all garbage. I also know that we have imperfect markets – so really, don’t bother.

For the rest of you, most of market economics is readily understood if you just look at your own economic decisions, and those of the companies/institutions you work for. Most of you already are practitioners of Libertarian free market economics, so when you hear people talk about recession like a bogey man, think again. It’s really just our economic ship righting itself.