Why Recessions Happen and How to Counter Them - Part I

by Sam Vaknin
The fate of modern economies is determined by four types of demand: the demand for consumer goods; the demand for investment goods; the demand for money; and the demand for assets, which represent the expected utility of money (deferred money).

Periods of economic boom are characterized by a heightened demand for goods, both consumer and investment; a rising demand for assets; and low demand for actual money (low savings, low capitalization, high leverage).

Investment booms foster excesses (for instance: excess capacity) that, invariably lead to investment busts. But, economy-wide recessions are not triggered exclusively and merely by investment busts. They are the outcomes of a shift in sentiment: a rising demand for money at the expense of the demand for goods and assets.

In other words, a recession is brought about when people start to rid themselves of assets (and, in the process, deleverage); when they consume and lend less and save more; and when they invest less and hire fewer workers. A newfound predilection for cash and cash-equivalents is a surefire sign of impending and imminent economic collapse.

This etiology indicates the cure: reflation. Printing money and increasing the money supply are bound to have inflationary effects. Inflation ought to reduce the public's appetite for a depreciating currency and push individuals, firms, and banks to invest in goods and assets and reboot the economy. Government funds can also be used directly to consume and invest, although the impact of such interventions is far from certain.

GOVERNMENTS

It is a maxim of current economic orthodoxy that governments compete with the private sector on a limited pool of savings. It is considered equally self-evident that the private sector is better, more competent, and more efficient at allocating scarce economic resources and thus at preventing waste. It is therefore thought economically sound to reduce the size of government - i.e., minimize its tax intake and its public borrowing - in order to free resources for the private sector to allocate productively and efficiently.

Yet, both dogmas are far from being universally applicable.

The assumption underlying the first conjecture is that government obligations and corporate lending are perfect substitutes. In other words, once deprived of treasury notes, bills, and bonds - a rational investor is expected to divert her savings to buying stocks or corporate bonds.

It is further anticipated that financial intermediaries - pension funds, banks, mutual funds - will tread similarly. If unable to invest the savings of their depositors in scarce risk-free - i.e., government - securities - they will likely alter their investment preferences and buy equity and debt issued by firms.

Yet, this is expressly untrue. Bond buyers and stock investors are two distinct crowds. Their risk aversion is different. Their investment preferences are disparate. Some of them - e.g., pension funds - are constrained by law as to the composition of their investment portfolios. Once government debt has turned scarce or expensive, bond investors tend to resort to cash. That cash - not equity or corporate debt - is the veritable substitute for risk-free securities is a basic tenet of modern investment portfolio theory.

Moreover, the "perfect substitute" hypothesis assumes the existence of efficient markets and frictionless transmission mechanisms. But this is a conveniently idealized picture which has little to do with grubby reality. Switching from one kind of investment to another incurs - often prohibitive - transaction costs. In many countries, financial intermediaries are dysfunctional or corrupt or both. They are unable to efficiently convert savings to investments - or are wary of doing so.

Furthermore, very few capital and financial markets are closed, self-contained, or self-sufficient units. Governments can and do borrow from foreigners. Most rich world countries - with the exception of Japan - tap "foreign people's money" for their public borrowing needs. When the US government borrows more, it crowds out the private sector in Japan - not in the USA.

It is universally agreed that governments have at least two critical economic roles. The first is to provide a "level playing field" for all economic players. It is supposed to foster competition, enforce the rule of law and, in particular, property rights, encourage free trade, avoid distorting fiscal incentives and disincentives, and so on. Its second role is to cope with market failures and the provision of public goods. It is expected to step in when markets fail to deliver goods and services, when asset bubbles inflate, or when economic resources are blatantly misallocated.

Yet, there is a third role. In our post-Keynesian world, it is a heresy. It flies in the face of the "Washington Consensus" propagated by the Bretton-Woods institutions and by development banks the world over. It is the government's obligation to foster growth.

In most countries of the world - definitely in Africa, the Middle East, the bulk of Latin America, central and eastern Europe, and central and east Asia - savings do not translate to investments, either in the form of corporate debt or in the form of corporate equity.

In most countries of the world, institutions do not function, the rule of law and properly rights are not upheld, the banking system is dysfunctional and clogged by bad debts. Rusty monetary transmission mechanisms render monetary policy impotent.

In most countries of the world, there is no entrepreneurial and thriving private sector and the economy is at the mercy of external shocks and fickle business cycles. Only the state can counter these economically detrimental vicissitudes. Often, the sole engine of growth and the exclusive automatic stabilizer is public spending. Not all types of public expenditures have the desired effect. Witness Japan's pork barrel spending on "infrastructure projects". But development-related and consumption-enhancing spending is usually beneficial.

To say, in most countries of the world, that "public borrowing is crowding out the private sector" is wrong. It assumes the existence of a formal private sector which can tap the credit and capital markets through functioning financial intermediaries, notably banks and stock exchanges.

Yet, this mental picture is a figment of economic imagination. The bulk of the private sector in these countries is informal. In many of them, there are no credit or capital markets to speak of. The government doesn't borrow from savers through the marketplace - but internationally, often from multilaterals.

Outlandish default rates result in vertiginously high real interest rates. Inter-corporate lending, barter, and cash transactions substitute for bank credit, corporate bonds, or equity flotations. As a result, the private sector's financial leverage is minuscule. In the rich West $1 in equity generates $3-5 in debt for a total investment of $4-6. In the developing world, $1 of tax-evaded equity generates nothing. The state has to pick up the slack.

Growth and employment are public goods and developing countries are in a perpetual state of systemic and multiple market failures. Rather than lend to businesses or households - banks thrive on arbitrage. Investment horizons are limited. Should the state refrain from stepping in to fill up the gap - these countries are doomed to inexorable decline.

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About the Author

Sam Vaknin ( http://samvak.tripod.com ) is the author of Malignant Self Love - Narcissism Revisited and After the Rain - How the West Lost the East.

He served as a columnist for Central Europe Review, Global Politician, PopMatters, eBookWeb , and Bellaonline, and as a United Press International (UPI) Senior Business Correspondent. He was the editor of mental health and Central East Europe categories in The Open Directory and Suite101.