Thoughts on the Economic Crisis, IV

In the previous three posts on this topic, I asked why don't we expect things to always be bad since we have a system in which no one is in charge of the economy. I then looked briefly at how markets work and at some sources of instability. I conclude in this post with a look at instability, rehashing some of what has been said before.
An important source of instability would be something that disrupts production of goods and services. Bad weather impacts agricultural production. A couple of years of drought can have severe effects on an economy, especially for a country that has a large agricultural sector. Several times over the last 35 years we have dealt with rapidly rising energy prices which disrupt production of energy-intensive products and of transportation. The large prices in oil that took place in 1973 and 1970 were followed by recessions.
These negative shocks tend to set in motion forces that correct the problem, but there may be a considerable lapse of time before normalcy returns. Higher energy prices encourage consumers to conserve and encourage producers to find new sources of energy or alternatives to specific forms of energy that have become more expensive. Higher food prices bought on by drought also encourage conservation, substitution to foods less dependent on large quantities of water, and the development of ways to tap into other sources of water, such as through canals, aqueducts, and wells.
On the positive side, innovations in the form of new products or improvements in production processes can spur economic growth and create a boom period. But this is still a source if instability. Innovations often generate new firms and industries while destroying other firms and industries. Joseph Schumpeter described this process in capitalistic economies as creative destruction.
Innovations are a catalyst to growth and change. Firms expand or new firms start up, increasing the demand for natural resources and labor and generating higher incomes and consumption of goods and services. If a particularly productive and fertile innovation has substantial impact on the economy there can be a fall back of growth if another equally-productive innovation does not come forth after the first innovation worked itself through the economy. What we have just described is a very simple version of what is known as real business cycle theory.
There are other problems that can develop in the real economy, but they do not tend to be systematic in nature. Mistakes on the part of firms in some industries can result in an excess supply or surplus of their good, forcing price down and perhaps forcing some firms out of business. But changing relative prices should correct things over time, and these issues should impact only some sectors at any time. We are interested in things that have economy-wide impact. While there are problem areas in the real economy, the problems should normally not be long term and rarely economy wide.
The production and consumption of durable goods are potential sources of instability. Durable goods, as opposed to nondurable goods or services, last and provide services to the user for several years or even a decade or more. Examples of durable goods include houses, autos, and regrigerators. (For record-keeping purposes, the government distinguishes a durable from a nondurable good by whether it is expected to remain in use more than three years or not. Some nondurable goods can last longer than three years—clothing for example—yet are treated in the data differently from refrigerators.) The purchase of durable goods can be postponed when the household is concerned about a recession.
Similar to consumer durables are capital goods purchased by business firms. . Capital goods are goods that are used to increase production in the future. Factories and much of the equipment in a factory are examples of capital goods. Capital goods also are durable goods. As durable goods, firms can delay purchasing capital goods when business is bad.
Capital goods and durable goods in general tend to be very pro-cyclical. That is, when the economy is booming, producers of durable goods and capital goods do very well; but, when the economy is in decline, producers of these goods see a sharp decline in their sales, revenues, and profits. Sales of durable goods are more volatile over time than sales of most nondurable goods or of services.
Real GDP has fallen about 2.5 percent since the official start of the recession. In contrast, the decline in investment spending by the private sector has been over 25 percent. Investment spending is more volatile, at least in part due to the durability of capital goods.
A market economy relies on money and financial instruments to operate smoothly. Studies have found that a developed set of financial markets enhances economic growth. But finance is also subject to wide fluctuations at times and can be a source of instability. We examine finance and money together because money can be viewed as a financial asset and because the Federal Reserve System’s operations, which controls the U.S. supply of money, affects interest rates and prices. Further, a link between finance and the real economy exists because capital goods purchases of firms and durable goods purchases of households usually are purchased by using financial and credit markets.
There is often a difference in timing of receipts and expenditures. People usually buy some durable goods, autos and houses to take two major examples, by borrowing funds and paying the loan off over time. Businesses build factories, malls, oil pipelines, and purchase other capital goods, often by means of borrowing or by raising funds through equity markets.
Finance is the mechanism through which the funds of those who want to save are provided to those who want to borrow. Some borrowing is done for consumption, but the largest use of borrowing is by businesses for investing. The investments enable firms to produce goods and services in the future. A decentralized market system cannot function without financial markets.
Many financial instruments are essentially IOUs. This is true of checking account deposits where the bank owes the depositor the funds, bonds where the seller of the bond owes the buyer funds to be delivered in the future, and loan instruments such as mortgages, car loans, and credit cards. Finance relies on promises and people keeping their promises. But, promises can be broken and both the borrower and the lender know that promises can be broken.
Promises can be broken because of malice on the part of the borrower, but promises can be broken out of circumstances as well. The future is uncertain. Expectations may not be met. A firm can invest in new production facilities for a new product with the expectation that they will be able to sell 10,000 units a month for $20 a unit. But when the product appears on the market at some later date, the firm can discover that people will not pay more than $12 a unit, and the firm cannot cover its costs. It goes out of business and defaults on its loan. If the future were certain, default would never take place.
Financial markets rely on trust. Lenders have to trust that the borrowers will be able to pay them back in the future, and that the borrowers will fulfill their promises. Due to the time dimension, the real economy also depends on trust. A parts manufacturer that supplies parts to automakers normally doesn’t expect payment for a few weeks. The parts manufacturer trusts that the automaker ultimately will make the payment. Recent events in the American automobile industry illustrate problems that can develop when trust no longer exists.
Risk is a part of financial markets also. Some financial assets have very low risk. Short-term government bonds are considered virtually riskless. Consequently, the return on short-term government bonds is very low. For other assets to sell in the market, they have to provide a greater expected return. People have to be compensated to take on additional risk. By taking on more risk, an investor can increase his or her expected return. But, the actual return could end up very large or could end up very small. Other things equal, the longer the time period the greater the risk.
Another way to increase return on an investment is to use leverage. Suppose someone buys 1000 shares of IBM at $100 a share. The investment is $100,000. If the price goes up 10 percent to $110, the value of the investment increases to $110,000 and the stockholder has earned a 10 percent rate of return. If the shareholder didn’t pay the full amount, but only paid 50 percent of the $100,000 and borrowed the other $50,000. Now, if the price goes up 10 percent and the value of the investment increases to $110,000, the shareholder has earned a 20 percent rate of return ($10,000, $50,000), If the shareholder only paid 10 percent and borrowed 90 percent, then the return would be 100 percent. Of course, stock prices can fall also. If that happens, the losses can multiply with leverage as the shareholder still has to repay the loan. The greater the leverage the greater the risk.
Moral hazard generates riskier behavior. Moral hazard is a term first used in insurance markets. It involves situations where the actions of the insured person affect the likelihood of the event that is insured against. By taking certain precautions, a homeowner can reduce the probability of a fire. If insured fully, the homeowner may not be as vigorous in taking the precautions as he or she would otherwise. The likelihood of a run on a bank is greatly reduced due to the presence of the Federal Deposit Insurance Corporation which insures deposits of most depositors. The bank has less incentive to be prudent and the depositor has less incentive to judge the riskiness of the bank. On a larger scale, if the people who run a bank believe they are too big to fail, that is the government will bail them out in the case of insolvency, the bankers have less incentive to behave prudently.
It should be obvious that there is greater potential for instability the greater the leverage is used in the buying of financial assets. Actually, this applies also to the buying of homes since the lower the down payment the greater the leverage and the greater the risk. When assets are purchased with a lot of borrowed money, they are riskier. If the asset prices fall, the owners face credit constraints that can lead to default. Default in some markets can spread to other financial markets, especially if financial institutions holding assets of other institutions whose assets are losing value.
As noted above, the Federal Reserve System (Fed) controls the money supply. It does so primarily through open market purchases and sales of government bonds. If the Fed is buying bonds, then the prices of bonds increase and the return on the bonds decreases. That is, the short-term interest rate falls. This action also increases the money supply by increasing reserves in the banking system, which allows commercial banks to make more loans. Economic activity increases as a result of the lower interest rate and increased quantity of money in the banking system. If the Fed sells bonds, the opposite happens—bond prices fall, interest rates increase, banks have less reserves and cannot extend more loans, and economic activity decreases.
One of the functions of the Fed is to maintain relative price stability. That is, it should prevent either inflation or deflation from occurring. In actual practice, the Fed is more concerned about deflation than inflation because deflation is often associated with severe economic downturns. The Fed seems to seek a relatively low and stable rate of increase in overall prices.
But the people who run the Fed are not omniscient and they make mistakes at times. When they do so, they may over stimulate the economy, leading to increased economic activity in the short run but higher prices in the long run. Inflation raises the cost of making informed decisions in the marketplace because people cannot be sure that changes in the price of a good are due to inflation or due to changes in the relative scarcity of the good. If fear of inflation is great enough, people end up spending real resources, including their time, trying to offset the effects of inflation rather than on economically productive activities. To reduce the inflation rate requires the Fed to restrict the rate of growth of the money supply, reduce economic activity, and often create a recession. The recessions in the early 1980s were created by the Fed in order to bring inflation under control.
Finally, two other areas can be mentioned briefly. The first is the international arena. International trade and finance provide many benefits but also can be sources of instability. Second, the government can be a source of instability. This can be through poor policy choices. It can also be due to time lags. In trying to prevent recessions the government, both the Fed through monetary policy and the federal government through fiscal policy, may alter policy. The government may increase spending or reduce taxes to stimulate economic activity. But, there are lags. There are lags in realizing there is a problem, lags in coming up with the appropriate policy, lags in implementing the policy and lags in the policy becoming effective. There have been times when the stimulus hit after the economy had already recovered, and ended up over stimulating the economy and generating inflation. As noted above, the Fed also can make policy errors.
The government can also fail to provide a stable environment. If the government changes the rules-of-the-game for the sake of expediency, or flip-flops in its regulations and enforcements, or over regulation, or shows favoritism to some groups but not others, the economy will not function as well.