No Pain, No Gain

 

By Peter Van Schaik

 

     In the world of physical fitness the often heard mantra is “No pain, no gain.” While this may be true when it comes to exercise, it is undeniably true when considering economic recessions.

     Although we tend to see recessions as an evil which must be avoided at all costs, they are really just a natural reaction to an over stimulated economy. If we want to avoid recessions, we can. We just need to avoid buying into the insane idea we can all consume vast amounts of imported goods on the easy payment plan without eventually facing negative consequences. We need to avoid buying into the equally insane idea we can all get wealthy making the same investments, whether we are flipping houses or buying and selling pieces of paper.

      A basic problem with capitalism is it does its job too well. It can fill vast amounts of human needs and desires but there are limits to the consumer’s ability to keep up with the productive capacity of capitalism. A profitable business idea comes along or a great investment appears and everyone wants in on the action. No thought is given to any limits of demand and soon the economy is overextended and a recession is required to cool things off.

     If production exceeds demand for too long, inventories build to the point where production is reduced. If debt growth exceeds the additional capacity to service the debt by too great a margin, borrowers begin paying down the old debt instead of borrowing additional funds. Either way, the economy cools and we have a recession.

     If the problem is simply over production a recession can bring about a reduction in production until excess inventories are eliminated. Unfortunately this tends to produce an increase in the number of unemployed. As unemployment increases and production decreases inventories can be reduced until they reach a level allowing a new period of sustainable growth. The process isn’t painless for those eliminated from the work force but it does allow for a relatively robust recovery if inventories are depleted to a low enough level.

     A recession brought about by a too rapid and large increase in debt requires a reduction in debt before a new sustainable period of growth can occur. A reduction in debt can be brought about two economically healthy ways: Either we can eliminate borrowing new funds and pay down our current debt or enough entities can go bankrupt and simply purge enough debt from the system. Either way, consumption is reduced and unemployment increased until we can once again afford to borrow enough for a new period of economic growth.  Either way we have a recession.

     There is another way to bring about an end to or to postpone a recession but I would argue it is the least healthy for the economy but probably the most politically acceptable solution to an impending or occurring recession. This path is to simply throw enough newly created money at the problem until it goes away. This can help in two ways: it can increase demand for some sort of goods and services and it inflates the currency which makes the current level of debt easier to service with the cheaper money. We have the problem of the additional debt to service, of course, but that is a problem for later and it’s generally ignored in a nation that can’t see past the next quarterly report. This is the route that we have officially taken to eliminate the current downturn.

     Since we are already deep into the downturn, the near trillion dollar stimulus package is an attempt to shorten the recession in spite of the fact that lower interest rates and the world’s central banks’ infusion of money into the various banking systems were probably enough to keep the recession to 20 - 24 months in length on their own. The problem with a stimulus package from Congress is the time lag it takes for monetary and fiscal stimuli to affect the economy. By the time the need of a rescue plan becomes obvious to all and by the time Congress argues over each and every minute detail in all the proposed plans, the recession has pretty well run its natural course.

     Even if the stimulus package shortens the recession, we will still have to eventually deal with the consequences of the increased deficit spending. Deficit spending isn’t necessarily inflationary: If the spending provides new goods and services which are purchased with the new money then all is well. However, if massive amounts of created money are spent on something like infrastructure there will be massive amounts of new purchasing power running loose in the economy chasing the same quantities of goods and services and we’ll have a massive dose of inflation.

     We’re a debtor nation and inflation favors those in debt so a bit of inflation can be beneficial and, at this point, absolutely necessary for our economic revival and survival. But the Fed keeps insisting its primary job is to control price inflation rather than asset bubbles so when the economy and inflation rebound the Fed will raise interest rates, once again over reacting on the upside, and in a year or two we’ll slide back into another recession. Then we’re right back where we are now with the additional burden of the larger debt.

     Bailing out bankrupt businesses with an increase in federal debt isn’t a cure for what ails us either. It only papers over and postpones the problem. If a business is inefficient, or can’t be competitive for any number of reasons, then it should be allowed to fail. When a business goes bankrupt the productive assets don’t disappear. They are eventually purchased by someone at a lower price than their current value which gives the new owner a better chance at competing both domestically and in world markets. Since the new debt is lower than the old debt, the total debt in the economy is reduced which is one of the positive effects of the recession. But the increase in federal debt used to bail out the failed companies at best just shifts the debt from the private sector to the public sector and at worst gives the economy more debt but either way it does little to stimulate demand. With so much of our capacity for production already sitting idle, there is little incentive for a business to expand unless we can first bring about an increase in demand.

     One problem with the whole supply side economics theory is supply will almost always respond to an increase in demand but demand won’t necessarily respond to an increase in supply. To stimulate the economy, you need to put the money in the hands of people who will stimulate the economy by purchasing real goods and services produced in the economy rather than paying down existing debt or investing in paper assets.

     To think we can have rapid and unlimited economic growth without any downturns is simply naïve. To think we can ignore asset bubbles and all grow rich and retire wealthy making the same paper investments is incredibly naïve. To think we can, as a nation, live way beyond our means without the bill ever coming due is way beyond incredibly naïve. The piper eventually demands to be paid and the longer we postpone the day of reckoning, the worse it will be. If we want to enjoy future economic gain, we first have to endure a jolt of economic pain.

 

 

Copyright 2009 – Peter Van Schaik

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