Monday, February 1, 2010

Recovery begins with certainty

Best analysis I have ever heard of the underlying cause of a recession:
A recession is not so much a stoppage of demand or supply as it is a rescheduling of big-ticket items.

The popular idea that the economy is driven by "stimulus" spending—as if politicians could capture and bring in resources from outside the economic system—is mistaken. Economies grow as the result of capital being put to work. Capital is plentiful. But it retreats in times of turbulence and uncertainty, coming back to work when uncertainty abates.
This is unbelievably spot on. A bubble is created by a misalignment of production with demand. The misalignment is inevitable in any system where production is based on predictions of an uncertain future. In essence, goods are produced today based on what we think people want. When the future doesn't turn out as planned (which it won't), we need to change what we produce. This constant churning of production to meet changing demand is called creative destruction and it is a very healthy thing for our economy.

The problem is that for the necessary readjustment to occur, for the economy to meet the new demand, what is currently produced must be changed to produce something else. This does not happen simultaneously, it takes time. People must be fired and re-hired, plants must be shut down and re-opened, and resources which were used to produce typewriters must now be used to produce laptops. This means that in order to expand, the economy must first contract.

But what really screws things up is not the necessary contraction, but the uncertainty associated with it. Uncertainty multiplies the contraction by idling resources which could be put to use. In effect, uncertainty causes people to wait and see. This situation, when resources which could be employed are idled, is known as the "output gap".

Obliviously we would like to eliminate this "output gap" (i.e. put idle resources to use). The idea behind government interventions such as spending or tax cuts, is that they will somehow "stimulate" these idle resources into production. The problem is that these measures treat the effect rather than the cause. The cause is uncertainty, and arbitrary government policies do nothing to reduce it, they make it worse.


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