You Decide: Is the economy inherently recession prone?
Date posted: August 15, 2014
Dr. Mike Walden
North Carolina Cooperative Extension
Most of us focus on decisions affecting our daily lives – earning an income, spending, investing, and looking ahead to our retirement. If we have some time left over, we try to have fun! Businesses face similar choices about production, advertising, workers, and pricing. Even public institutions like schools, parks and transit systems have to make a wide range of management selections.
Economists call these types of choices microeconomic decisions because they deal with individual entities, such as a household, a business or a government agency. These entities are trying to make decisions to advance their overall objective, like happiness for a household or profits for a business.
However, we don’t live in our own individual economic worlds. Our economic worlds are interconnected. Individuals earn income by working for businesses. Businesses earn income by selling to individuals and to other businesses. Governments levy taxes on individuals and businesses and provide services like national defense, the court system and roads.
Putting these individual economic players together forms the macroeconomy. Until a century ago economists didn’t pay much attention to the macroeconomy. Then came the “Long Recession” of the 1870s, the “Great Depression” of the 1930s and several other less serious economic downturns interspersed.
It became abundantly clear that changes in the big, interconnected macroeconomy could adversely impact households and businesses – even if those households and businesses were making the best economic decisions for their individual situation.
A great deal of economic brainpower has been expended in the last century attempting to understand the macroeconomy – and particularly what causes the macroeconomy to periodically go into a tailspin. One conclusion that some economists have reached is, perhaps, rather startling. It is that the macroeconomy is inherently unstable and recession-prone.
The argument is actually simple. When the economy is doing well and expanding, sales and profits increase, incomes grow and optimism about the economy’s future becomes more widespread. People see nothing but “blue skies” ahead. Lenders feel the same way, so they lower lending standards to allow both households and businesses to take on more debt.
All is well as long as the economy grows and nothing happens to disrupt the general optimism. Yet it could be something small, like an uptick in interest rates or lackluster corporate earnings, or it could be something big, such as a foreign war or international default, that ultimately upsets the good feelings.
Once optimism about the economy is shattered, people begin to worry. Investors sell rather than buy. Businesses delay expansion plans and cut payrolls. And, perhaps worst of all, some households and businesses find they now can’t meet the payments on their debts. If lenders, such as banks, aren’t paid and depositors fear their money isn’t safe, a “run on the banks” can set off widespread economic panic and a macroeconomic recession – or worse.
We saw this scenario unfold during the most recent recession. Optimism about the economy and particularly the housing market fueled record-high debts in the early 2000s. But pessimism took over in the late 2000s and the economy experienced the housing crash, debt defaults and the worst recession in 70 years.
We now have institutions and programs, like the Federal Reserve and federal deposit insurance, to cushion the blows of recessions. There were no bank-runs during the recent recession, although there were “runs” on non-bank lenders, and the Federal Reserve had to scramble to contain them.
Still, if we know that excessive economic optimism eventually leads to unsustainable borrowing and a recessionary correction, can public policy makers impose controls to bring more stability to the economy?
This is a big, big question in economic policy circles – one that has been debated for decades. One option is for government to attempt to moderate the growth of credit during “boom times.” The Federal Reserve has some tools to do this, including the ability to limit the amount of bank deposits that can be loaned, as well as the interest rate charged on loans. Also, federal legislation passed in the aftermath of the recent recession has added some further restrictions on bank lending.
Of course, such controls and limits have downsides because they restrict the ability of borrowers to obtain funds which, in turn, causes the economy to grow slower than it would have without the controls. This is a common explanation heard today why business expansion and job growth are lagging in many parts of the economy.
So our economy may have – as part of its nature – periods of ups and downs related to general feelings of optimism and pessimism. Do we have to live with this cycle, or is there a way to have a smoother economic road ahead? Thousands of smart people have tried to answer this question. You decide if they’ll ever get it right!
Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks.
Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide
Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective
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