What Causes Recessions – Or – Goods Buy Goods

By Martin L. Mazorra, Special forUSDR.

During a recent episode of CNBC’s Kudlow and Company, Larry (Kudlow) gave his analyst guest the last word; she justified her optimism for the stock market by the fact that consumer sentiment is on the rise and that “consumer spending is 72% of the economy”. Larry closed the evening’s show by telling his guest that she had it “almost right”; that what this economy needs is more saving and more business investment, as opposed to more consumption. I don’t always agree with Mr. Kudlow, but in this instance I believe he was spot on— except for the part where he said she had it “almost right”; she was at least 72% wrong. Of course her assertion that “consumer spending is 72% of the economy” comes straight from the GDP equation; an oft-quoted justifier for policies aimed at boosting demand. Once upon a time, I fell prey to the samemisconception.

Here, from page 26 of Steven Kates’s Say’s Law and the Keynesian Revolution, is a more accurate description of what grows theeconomy:

If one takes the annual produce of a country, writes Mill, and divides it into two parts, that which is consumed is gone. On the other hand, that portion which is used in the production process returns in the following year, with a profit. The more of the produce of a country that is devoted to productive uses, the faster that countrygrows.

And (from page 40) on the cause ofrecessions:

The basis of the law of markets is that goods buy goods, but only if the right goods are produced. If the wrong goods are produced, then they cannot be converted into the universal equivalent (i.e. money). If a proportion of goods cannot be sold, then their owners cannotbuy.

If one set of producers cannot buy, then a second cannot sell. The result is a general downturn in the economy and warehouses filled with unsold goods. But the cause of recession is not demand deficiency or over-production but the production of the wrong assortment of goods and services. The adjustment process thus required is the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced. There is no reason that the process of readjustment will be rapid, but there is also no reason to believe that the downturn will bepermanent.

So then, under whose command of resources should we expect the greatest likelihood of producing the right assortment of goods and services; self-serving producers of goods and services, or self-serving politicians? Certainly the market, all on its own, can produce the wrong assortment of goods or services. However, left to its own devices, and to natural consequences, the market will—painfully for some—adjust accordingly. Politicians, on the other hand, have a professional interest in circumventing the suffering of their supporters, and are therefore adept at neutralizing the natural consequences for the producers of the wrong goods by spreading the loss among the entire population. And, alas, they in effect compromise the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced: hence, a very slowrecovery.

When one ponders the 2008 recession, housing comes to mind. Explicitly government-backed mortgages (Ginnie Mae), government-sponsored enterprises (Freddie and Fannie), and a variety of tax breaks are the brainchildren of politicians incentivizing the production of a particular good. Plus, in response to the 2002 recession, the Fed took aggressive measures to keep interest rates low and, in the process, flooded the financial sector with liquidity enough to fund the manufacture of trillions of dollars worth of derivative securities designed to leverage—many times over—the housing market (a level of risk-taking inspired by a morally hazardous history of financial sector bailouts). In the end we had the definition of resources diverted to the production of the wrong good and thus the greatest recession since the GreatDepression.

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