Depressions Cause a lot More Pain than Benefits-Becker

Some older theories of business cycles-usually associated with the "Austrian" school of economics- claimed that recessions and depressions were useful in helping to remove the poison from an economy that builds up during good times. For example, weaker companies are the first to go when the demand for an industry's product falls during recessions. Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs. Positive effects such as these may be somewhat important during very mild downturns, but they are overwhelmed during major recessions and depressions by the negative effects. I define a "major" recession as having an extended period of unemployment rates at 9 percent or more, coupled with declining GDP. It looks like the US and the world economies may be headed for such a recession for the next year or so. Economists have underplayed the cost to individuals of mild to severe recessions in part because they have neglected the cost of the "fear" generated by bad economic times. In his1932 inaugural address in the midst of the Great Depression Franklin Delano Roosevelt reassured he American public that the "Only Thing We Have to Fear Is Fear Itself". In fact they had a lot more to fear, but Roosevelt recognized the great importance of fear during depressions. In the present crisis too, consumers and workers have multiple fears due to various kinds of uncertainty. Homeowners fear that they may lose their homes after having used most of their savings as down payments on their homes. The employed fear that they will be laid off, while the unemployed fear that its duration will be quite long, and that they eventually will only get jobs that are much inferior to the ones they had. To be sure, some of the unemployed in many countries will receive unemployment compensation, but many unemployed American do not qualify for this benefit. Moreover, unemployed workers in this country usually receive much less than their earnings while employed, and after a while they run out of benefits, although benefits get extended during recessions. The fear about losing one's job interacts with fears about being unable to make payments on homes, cars, and other consumer durables. Unemployed persons start missing payments on their homes or cars. If this goes on for several months, they may have their cars repossessed, and their homes put into foreclosure, usually at a time when home prices are down a lot, so that can at best regain only a fraction of the equity they put into their homes. In addition, the burden of a major recession is not shared uniformly. It usually falls disproportionately on unskilled workers, the young, and those in shaky financial positions, which tend to be persons with lower educations and incomes. For example, the unemployment rate of high school dropouts is traditionally several times that of college graduates, so when the average unemployment rate goes from 6 to 9 percent, that of college graduates may rise to about 4 percent, while that of dropouts will increase to over 20 percent. This recession may be a bit different since the financial sector is being hit so hard. Individuals and families already in shaky circumstances get hit especially hard by major recessions. It is relatively easy to measure what happens to the unemployment rate during recessions and its differential incidence among different groups, or the number of persons who drop out of the labor force because they despair of finding a job. One can also measure relatively accurately the effects on profits, wages, the path of GDP and personal incomes, and other important variables. It is far harder to measure precisely the effects of serious recessions on individual welfare and happiness. Surveys of reported happiness find that workers who become unemployed are less happy than they were, and persons whose incomes have fallen reported a decline in their happiness, at least initially. Divorce rates and even suicide rates also tend to rise during major recessions, as does crime, discrimination against minorities and immigrants, and pressure toward greater protectionism. Relative to these major costs, the alleged benefits of a recession to the United States seem quite small, and some of them could also be costs on balance. For example, how many infrastructure projects can be undertaken when states are already running deficits, and face even larger ones in the coming months? The federal government will have a huge deficit during the next year, perhaps a trillion dollars, because of the $700 billion bailout, the stimulus package, and the expected sharp declines in tax revenues. A serious recession will certainly lead to increased regulation of business and labor markets. Some greater regulation of financial markets would certainly be desirable, as I have argued in prior posts, but some of the likely new regulations will be harmful, such as greater protectionism, wage-type controls over income of top executives, higher taxes on capital gains, and others. The decline in oil prices by over 50 percent to $60 or less a barrel will certainly help American consumers and companies since the US imports about 2/3 of the oil it uses. It is also helpful to American interests to have less revenue flowing to Venezuela, Russia, and some of the Middle Eastern countries. On the other hand, the US is a major exporter of grains and beef, and the decline in their prices will cause considerable problems for farmers. On balance, I believe the decline in commodity prices is a plus for the US, but not a huge one, especially if oil prices begin to rise sharply after the world recession is over. A serious recession will further erode the pay and bonuses of top executives at financial and other companies, which many will be happy to see. Managers of mutual and hedge funds and investment banks may have been making much more money than is justified by their productivity, but surely the misery inflicted on the lesser skilled workers, low income families, poor homeowners, and other economically weaker groups is not worth any benefits from a sharp fall in the incomes of those at the top. So my bottom line in discussing the question whether depressions have a silver lining is that any such lining is very thin and small compared to the major costs to households, workers, and small businessmen.

Comments

[Devin Finbarr]

That's quite a misrepresentation of Austrian position. The Austrian theory stems from the fact that banks loan out the same money multiple times. Because of this, money ends up getting loaned out for thirty years, despite the fact that the initial depositor had no intention to commit his money that long. Long term projects are initiated using the cheap credit. At some point, the depositors want their money, and find that the bank does not have it. A bank run occurs, the bank cannot make loans anymore, credit dries up, and businesses fail.

The Austrian is actually an optimist and believes that if lenders simply matched maturities there would never be a business cycle. Businesses who wanted to initiate long term projects would find people saving for retirement who wanted to make long term loans. There would be a constant level of strong economic growth. It would be a perpetual boom.

[Nate]

Based on my understanding of the Austrian Theory of the Business Cycle, I think you're misrepresenting it a little bit. ABCT merely shows that artificially low interest rates mess with market signals and lead to a distortion in the inter-temporal structure of capital. A recession is a necessary liquidation and adjustment period that brings the capital structure back in line with the underlying time preference of society. It's not really saying anything about a silver lining.

[Chase Mechanick]

Well argued, Mr. Becker.

As for the previous comments, the Austrian Theory of the Business Cycle submits that an expansion of the money supply both increases investments by firms in long-term capital goods - new factories, tools, etc. - and decreases the rate at which ordinary citizens save. The Austrians claim that this skews the "inter-temporal structure" of the economy. As people save less, they want to consume more; but the short-term consumer goods that people demand are mismatched with the long-term investments made by firms. Therefore, because there is no "demand" for long-term capital investments, these investments turn sour and are liquidated, causing unemployment.

Krugman has a good article debunking the Austrian Business Cycle Theory: http://www.slate.com/id/9593. Regardless of what you think of Krugman, he makes some very good points:

1) If recessions occur when there is a surplus of demand for short-term goods over long-term goods, this would mean that recessions are caused by consumption booms, which is not the case.

2) In recessions, all industries contract, whereas the ABCT suggests that contractions only occur in the investment sector.

3) Switching from the investment sector back to the production of consumer goods should not cause unemployment, it merely replaces some jobs for others. The only cause of unemployment in that situation would be the friction from this transition, but then shouldn't the initial switch from consumer goods to capital goods also cause unemployment?

[Maurizio Colucci]

@Chase Mechanick

Here is a response to Krugman

http://mises.org/story/3155

where Murphy argues that Krugman did not understand the Austrian theory.

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[sindibad]

Your post seems to have a fundamental misunderstanding of the Austrian Business Cycle Theory: you mistake its descriptive account for a prescriptive value judgment about the benefits of depression.

The ABCT does not think the depression is a good thing, it merely acknowledges it as the natural outcome of years of misguided monetary policy. It's bad, painful and terrible, but it is needed to cure the economy of the ills of malinvestment, wrought about by wrong-headed monetary policy.

This does not make Austrians cheerleaders for depressions; it only says that they will be inevitable corrections of previous mistakes.

Arguing that a cancer patient needs chemotherapy doesn't make one a fan of harmful radiation or cancer; it merely states that that is a necessary cure for the real problem, the cancer.

[David Heigham]

First, depressions - extended severe recessions - are disasters. They cause a great deal of human misery. Fortunately, there is plenty of theoretical and scholarly work which suggests tha they are avoidable; and the man now at the helm of the Fed is as good an expert on the subject as we have.

Second, there is no solid body of theoretical or scholarly work which suggests means of reliably avoiding recessions. In summary, the observations are that claims which will not be paid in full and assets which will not be disposable at their valuations both accumulate in our economies. Recessions are the moments when a chain reaction of default and/or falling prices of assets results in economic agents cutting consumtion and investment to adjust their balance sheets.

Third, monetary policy is our instrument for maintaining a rough grip on trends in the general price level. If inflation gets out of hand, the damage will be severe and lasting. Monetary policy will influence the general level of demand; but that is a by product, not its principal objective. Further, though it can reduce the likelihood and severity of recessions, monetray policy alone cannot prevent the accumulation of mis-valued claims and assets.

Fourth, active regulation could, in theory, reduce the accumlations of claims unlikely to be paid in full. To date, however, regulators have shared market blindness to these.

Finally, it follows that the prudent longer view of recessions is to plan on the basis that they will occur, to have policies on the shelf for shortening them; policies which will turn on forcing swift and full recognition of the mis-valuations, and then on applying pre-prepared fiscal stimuli aimed at reparing any asset deficit in public services as well as at reparing balance sheets. Short, sharp recessions should have many of the silver lining benefits that Posner sees; without leaving us struggling in the awful dragging swamp of a deression.

[Wylie Axford]

1. Sam Walton had it right. All employees should have stock in the company they work for. The problem Sam had is that when an employee had a need for funds, Sam had no way to prevent the employee from selling his or her stock, thus they were reverting back to just a hourly worker. Social Security is facing a deadline for providing future retirement income now that the baby boomers are entering the picture. Our resorces are not going to be able to meet these demands without just printing more and more paper debt. If the government can guarantee certain savings in bank accounts through the F.D.I.C., why not establish a program that would require that every employee own a regulated block of stock (Retirement Account) made up of stock in the company the employee works for and, so the employee will not have all his retirement eggs in one basket, include is this retirement basket high rated stocks from other non competeing companies. It seems to me the goverment could guarantee these programs as they do through the F.D.I.C regulated plans. This would be less expensive to taxpayers than trying to overhaul and fund social security. Most young people I talk with NOW, state they don't think Social Security will be available when they retire.

Just as we provide student loans to help provide a college education, we should consider providing employment loans that the employee would pay back as a regulated payroll deduction. Provisions could be made in the G I Bill program earmarking a part of the package to provide the funds for the purchase of the stock package for those leaving the military in search of employment. When the startup package is paid for it would be mandatory that the deductions continue and the employees retirement package would continue to grow untill retirement. If the employees employment is terminated prior to retirement the government would establish policy for an escrow pending re-establishing or tranferring the fund with a new employer. Including cases of no employment available or dissability.

Think about the effect this would have on startup busineses, where each employee hired is bringing not just his or her skills, but also bringing investment capital.

Think how customers would be treated by employee owners, and the respect customers would have for employees when they know this person actually does own the company.

Why would a corporaton want outside investors electing CEO's and board menbers? I feel all corporations should have at least 51% employee ownership.

2. Outsourcing. Our country could take into consideration the wages, working conditions of manufacturers in other countries that want to export to the USA. For example, if their wages are 75% on average lower than US averages, why not tarriff them 75% so the playing field is level?


3. Vegas & Wallstreet. We need to take the Las Vegas mentality out of Wall Street. Vegas has been ahead of Wall Street on this for along time. For instance, if you're a card counter playing Black Jack in a Vegas casino, even though card counting is legal (like selling short or certain other option trading is legal), when you're disscovered, the casino has the right to ask you to leave and even ban you from coming back. Why can't Wall Street take the same position on trading that is detrimental to the overall health of the stock market?

4. Fiduciary responsibility & Golden parachutes, It's a well known fact that institutional and private fund investors, by virtue of the scale of their collective investments, have enormous influence over financial markets and the global economy as a whole. In 1999 United States public pension funds alone had assets representing 46 percent of the gross domestic product and 33 percent of the New York Stock Exchange’s capitalization. Additional holdings by religious, educational and public institutions, unions and foundations further increase these numbers.
As a result, these institutions’ financial decisions have a huge impact on society. The collective power of these institutions could be limmited to 10 to 15% holding in any one corporation thus reducing their power to control the election of CEOs and board members along with their outragous contracts that include multi million dollar bonuses and golden parachutes.This action would tend to secure the short and long term interests of employee owners beneficiaries, and other shareholders and stakeholders alike.

The realities of the 21st century require fiduciaries to be concerned with the impact of financial, social and environmental factors on the performance of investments to fulfill their legal obligations and maximize shareholder value. In addition, as employee owners, fiduciaries have the duty and the opportunity to promote good corporate governance to protect the assets under their care, and because the corporation is at least 51% employee owned the focus of the CEO and board is not just the bottom line,

The employee owner concept asserts that the integration of prudent financial management practices with principles of environmental stewardship, concern for community, labor and human rights, and corporate accountability to employee sareholders and stakeholders – which have not been considered relevant to the financial decision-making process by investers. These outside investors with no other relationship to the company or employee than ownership of it's stock tends to constitute in fact a single bottom line concept. In order to guarantee long term sustainability, to minimize long and short term financial risk, the definition of fiduciary responsibility has to evolve. This would preclude golden parachutes.

Wylie Axford

[Gu Si Fang]

Pr Becker,

Thanks for mentionning the ABCT. It is better to see this theory discussed than absent of the mainstream discussion. However, it is ofter misunderstood and misrepresented. Several points should be clarified :
- the most frequent confusion concerns overinvestment vs malinvestments, as in Krugman's "hangover thoery"
- the recession is unavoidable - rather than "good" or "useful" - because the long-term projects that have been started during the boom cannot physically be completed under current consumption trends
- the bust is the moment when most people realize that their expectations cannot and will not be met, and therefore revize their expectations
- the recession is the phase during which the allocation of ressources adjusts to these new expectations
- the depression - which is NOT part of the ABCT - is what happens as a secondary phenomenon when measures such as wage and price controls, public works, bailouts, etc. are enacted

The overinvestment vs malinvestment confusion can be clarified by reading these essays : http://mises.org/pdf/austtrad.pdf

That the recession is unavoidable is the crux of the matter, and not obvious at first. Mises provides a parable with house builders to illustrate this idea. It is presented in a simple fashion here : http://www.auburn.edu/~garriro/ivan.ppt

The one good thing about the bust is that people start having realistic expectations. It is useful in that it allows them to start projects which are moke likely to be successful. Had their expectations remained unsustainable due to the monetary distorsion of relative prices and interest rate, they were likely to fail 'en masse'.

The recession is also "good" unless one considers that production should not meet consumer preferences. This would be the case if no adjustments took place in the allocation of labor and investments. These adjustments have no reason to take much time. But if a major recession is defined as an extended period with more than 9% unemployment, this is an entirely different issue. Any definition is acceptable as long as we know which one is being used.

[Juan Fernando C.]

Prof. Becker:

It's not "during good times" that the poison builds up, to use your metaphore of choice. It's during a misplacement of resources provoked by an increase of credit without real savings behind it. Had the Chicago School a satisfying capital theory, this point would be easier to explain to its leading exponents. But the lack of it obscures how important the interest rate is as a reflection of people's agendas in time as credit takers and givers. Meddling with it makes projects artificially profitable and leads to a later bust. A recession/depression is not like other liquidations the market generates: it's a systemic error that is being corrected, not only individual entrepreneurial error as other weeding out that the market would do. So us Austrians don't salute recessions per se, only those that come after central banks or other monetary destructionist institutions have provoked a misplacement of funds, leading to the inevitable destruction of wealth. A correction is needed before growth can take place again on a realistic basis.

[Dan]

Another serious long-term consequence of severe recession/depression is caused by a decline in Research & Development funding. In the U.S., for example, public sector research funding from NIH and Department of Defense inevitably results in fewer patents and innovations reaching the market.

[Bob.K]

Austrian Theory actually predicted the current banking and housing mess. This is a huge accomplishment and a demonstrates that it has a lot more predictive power than rival schools as the Chicago a.k.a. monetarism, and keynesianism.
That's why Krugman and Roubini always check mises.org in search of predictions. But they later claim all the credit, and then propose the keynesian medicine, but remember, they did not use Keynes to come up with the predictions, so their medicine will not work. Why it should?

[nathan]

"Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs."

not sure this is true.

and how do you measure "hard work"? # hours worked? judgement? innate ability? certifications and education brought to the job market?

[Tim]

Professor Becker:

I think the problems go well beyond what is discussed in your and Professor Posner's articles on this topic. There has to be a reason all this cheap money was flying around, and that same reason demonstrates why all these people have to pay a tough price as the economy recedes to gobble up the overgrowth in GDP that has been observed the last few years.

It is a shame that this had to stain Greenspan's legacy after so many years of hard work, though.

[T V Selvakumaran]

In his article posted on http://www.becker-posner-blog.com/archives/2008/11/does_the_ free_m_1.html, Professor Gary Becker examines the mechanisms available within the free-market framework which could prevent corrosion of moral character. Particularly, (i) he analyzes the mechanism of repeat-business thoroughly, (ii) he explains the role of the free flow of information to consumers on collusion and other malpractices, if any, so that they can punish dishonest businessmen, (iii) he mentions the phenomenon of default-judgment to suggest that people might be favoring government regulations just because they are encountering problems with free markets, (iv) he explains "capture theory" to illustrate why regulations could make the situation worse. Finally, he employs the default-judgment argument once again to pose the question whether businessmen or professors have the worse morality.

Pursuing Professor Becker's mechanisms approach further, I would like to argue that the nature of technology itself is relevant to this topic. During the last 100 years, technological change has been happening at a breathtakingly rapid pace, much faster than in earlier centuries. The period of time that a certain technological development would be considered "cutting-edge" does not exceed five to ten years in most cases. In contrast, the universities teach general principles that would benefit the students throughout their lifetimes.

This is true both for the liberal arts curriculum and the engineering disciplines. Training in the latest technology or other vocationally beneficial topics would constitute only a minor part of the students' curriculum. In contrast, nearly every company is dependent on technology, in some way or the other, for its source of revenues. This dependence makes it necessary for the companies to put a far greater value on a different set of skills among their employees. As I will explain, this variance of "ethos" between the universities and the companies is a source of corruption which gets amplified by free markets.

I think it can be safely assumed that socialist and communist forms of governments are not very adept at absorbing rapid technological changes. Through the theory of marginal utility, the market framework is able to deal with rapid technological changes, although it can often seem that the behavior of the markets is chaotic and aimless. Companies that hope to survive in the marketplace have to keep-up with the cutting edge of technology.

In fact, abstract concepts like technological development, innovation, and human capital, rather than tangible goods or agricultural products, are what account for the predominant share of a nation's economic value in modern times. Invariably, this means that the student who graduates with a university degree, whether a bachelor's, a master's, or a doctorate, is in need of further training, the complete duration of which could range from six months to several years, to be able to function well as an employee in the company.

Moreover, this fresh graduate is expected to re-orient his/her core values to fit in with the vaguely defined notion called company ethos. As a result of this fitting-in process, it is quite often the case that most of the individuals whom the universities rated as top-class are not going to make it to the top of the modern company organizations. In fact, if one were to survey the Fortune 500 companies, the rapidly growing Silicon Valley software companies, or the finance companies in New York, the top management would not constitute many 4.0 GPAs or many PhDs from the top-ranked universities of the world.

It is this sudden discontinuity in the value system that the fresh graduate encounters that is the cause that leads, in later years, to much cronyism, influence-peddling, and other nefarious activities in the more senior levels of the modern company organization. The university system focuses on values that are well-defined and well-understood. This makes the value system fairly stable, and thus allows for a meritocracy among students. Those with the most natural gifts and those who put in the most hard-work are the ones most likely to succeed. In stark contrast, in a company organization, individual merit alone will not lead to career success.

The importance of this issue becomes clearer when one notes that in modern economic analysis, participants in an economy are rational decision-makers, for the most part. However, the fresh college graduate does not get such an environment that encourages rational thought when he is employed by a company. Almost always coercion is present.

Another point to note here is that free markets aim to minimize the influence of power. The same is true of the university system, where the love for learning among students, or the love of their own careers, leads to their good behavior. The exercise of administrative power to correct a student's behavior is rarely necessary. However, by its very structure, the company organization is set up to remind the fresh employee, not wholly infrequently, about his/her place in the hierarchy of power. This introduction of power into the immediate environment of the fresh graduate is another major cause for the corruption of the value system of company executives.

In conclusion, the nature of technology and the structure of the modern company organization, rather than free markets, could be the reasons for the corruption of moral character among businessmen. I would not like to give the impression that technology, in itself, is bad.

[shelley]

好与不好，其实是因人而异的。站在不同的高度和角度，会有不同的答案。就我目前的能力阶段，我认为这次的金融危机对世界是利大于弊的。

[shelley]

好与不好，其实是因人而异的。站在不同的高度和角度，会有不同的答案。就我目前的能力阶段，我认为这次的金融危机对世界是利大于弊的。

[Chris Graves]

I appreciate the reference that Professor Becker made to the Austrian theory of the business cycle. While I agree with him that recessions (depressions) come with a terrible price, I am more in agreement with Judge Posner in this go-around on there being an upside to downturns in the economy. I believe that there is more to the Austrian view (Hayek, Mises, and more recently William White) than Professor Becker discusses at the top of his essay this week. In addition to the points he makes about the internal efficiency of firms being shored up in a recession, there is the problem of misallocation of economic resources that are brought on by an expansionist monetary policy pursued by the central bank. On Hayek’s theory, a recession can bring savings and investment back into equilibrium. As this adjustment process occurs, the economy as a whole is brought back to a sound footing as investments are liquidated that could not be sustained over time due to entrepreneurs being misled by artificially low interest rates to overinvest in projects in which there is inadequate effective demand over time. As these projects fail, the resources that were diverted into their production can be freed to produce other goods and services that can be perpetuated since they have sustainable funding and market demand.

The fundamental problem with Monetarist explanations for the business cycle is that they accept the basic Keynesian model of the economy while only disagreeing with several key aspects of the empirical validity of the paradigm and resulting policy prescriptions. Monetarists along with Keynesians overlook the importance of interest rates in signaling entrepreneurs to undertake risky investments. They also overlook Say’s Law circular flow especially in the area of savings needing to equal investment spending. As long as investment spending can be stimulated, even if it is stimulated out of thin air by injections of credit into the market, that is all that matters on the Keynesian/Monetarist view. Monetarists following Keynes simply aggregate all spending including all investment spending. In effect, Monetarists have no real theory of capital formation. Frank Knight believed that once the capital structure was in place, there was no need to replenish capital over time drawn from savings. Monetarists also over-aggregate investment spending by failing to recognize that there needs to be a stream of capital spending to support the construction and purchase of different tools and plant in different time periods in which various stages of production are brought online. Each capital good is complementary to a certain optimal mix of production goods needed to complete the production process at each stage of production. If the production process cannot be sustained because entrepreneurs have been misled into believing that there will be adequate demand and savings to complete the project at all stages of production, then they will be forced to abandon the long-term projects before completion. The long-run depletion of capital and the lack of sustainable demand sets off the liquidation process that we identify as a recession. If the central bank simply re-inflates the economy by injecting more money into the economy by artificially lowering interest rates, the economy is misdirected even more severely requiring a greater adjustment process (i.e., recession) later. This entire process of artificially injecting money into the system is the underlying cause of the boom and the bust later.

During his tenure at the Federal Reserve, Alan Greenspan continually sought to create a soft landing for the economy after each bubble played out by injecting greater amounts of money into the economy. Each time he did so, an economic recovery would develop into another bubble followed by a subsequent bust, and there we would go again. To avoid the ill-effects of the necessary adjustment process, a recession that liquidated the misdirected assets, he simply kept re-inflating leading us to the breaking point we are now in.

Hayek was especially critical and bewildered by the Monetarist blindness to why injections of money into the economy by artificially lowering the interest rate were harmful. On Hayek’s understanding, injections of money into the system by lowering the interest rate changed relative prices making unsound investments appear to be sound as these investment projects misdirect resources away from more sustainable and needed investments elsewhere. Monetarists overlook the fact that excessive monetary expansion might not show up in changes in the general price level, but will create distortions in the relative price level that have no basis in changes in real economic variables. A recession can restore clarity and responsiveness to the system by removing these distortions in investment spending created by the overly aggressive monetary policies enacted by the central bank.

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