28 December 2008

Recessions Explained

Paul Krugman's 1998 Slate article explains
  • But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? Don't say that it's obvious—although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought—a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump....
  • ....As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

6 comments:

Elizabeth said...

Yes but even as Washington tries to rescue the economy, the nation will be reeling from the actions of 50 Herbert Hoovers — state governors who are slashing spending in a time of recession, often at the expense both of their most vulnerable constituents and of the nation’s economic future.

Elizabeth said...

Max Pucher gets at the same point Why should we have a cost focus now? Do people not know that by spending less they are actually deepening the recession? Funding should always be difficult to get and not just in tough times. That is already one core problem of large businesses right there. Good management concepts don’t change when the economy changes because it takes the totally normal economic cycles into account. What do MBA’s learn these days?

Ian said...

Krugman gives Elizabeth and Max a theoretical foundation:The bottom line is quite striking: aside from some qualifications I’ll discuss at the end, when the economy is in a liquidity trap government spending should expand up to the point at which full employment is restored. That’s not a guess or a statement of personal preferences, it’s a result.
The basic intuition behind this result is that when the economy is in a liquidity trap, the social marginal cost of government spending is low, because there isn’t enough private demand to fully employ the economy’s resources. This means that we would normally expect more government spending to raise welfare, right up to the point that full employment (a concept that needs a bit of explanation here) is restored. At that point the marginal cost of government spending jumps up, because it’s diverting resources from private spending.

Laurie said...

More comments on Sequoia's “R.I.P.: Good Times”.

Ian said...

Backgrounder on John Hick's IS-LM.

Ian said...

Krugman again. Liquidity Traps:
Under what conditions will a liquidity trap occur? One possibility is that P is high compared with P* - that people expect deflation, so that even a zero nominal rate is a high real rate. The other possibility, however, is that even if prices are expected to be stable, yf is high compared with the future - or to put it differently, peoples' expected future real income is low compared with the amount of consumption needed to use today's capacity. In that case, to persuade people to spend enough now may require a negative real interest rate, and with downwardly inflexible prices that may not be possible.