What Causes Recessions?

Your next question ought to be, what causes that drop in aggregate demand? A lot of factors can be the culprit. And one of the potentially confusing things about understanding the economy is that nothing happens in a vacuum. All of the factors that affect economic performance are happening at the same time.

• First is the business cycleThe regular if unpredictable fluctuations of the private economy, typically featuring periods of expansion followed by periods of contraction.: The business cycle is the ups and downs of a market economy. It’s not really a cycle, in that it’s not predictable, but it is a cycle in that it seems inevitable. (Economic policy makers can sometimes be heard to say that they’ve “solved the business cycle,” from U.S. officials in the 1960s to Chinese officials today, but it ain’t necessarily so.)

  A business cycle looks like this: Let’s say there’s been a boom somewhere in the economy, say the internet and telecommunications as happened in the 1990s. New products and services mean that consumers rush out to buy these new products, which leads entrepreneurs to start new firms and existing firms to expand production. That means more hiring and higher wages and general economic expansion. Things are good, and, inevitably, somebody says “the old economy is dead. This time is different.” (When you hear that, grab your wallet: The end is near.) But nothing grows forever. Eventually, markets mature, sales level off or fall, firms begin to lay off workers or even fail, and suddenly the endless boom begins to look like a recession. Some economists refer to these periods as bubbles, and bubbles eventually burst. Overinvestment in railroads contributed to the many panics of the 1800s; ditto for automobiles and radios in the 1920s; blue chip stocks in the 1960s; the internet and telecom in the 1990s (leading to the recession of 2001); and the housing bubble that led to the Great Recession of 2007. If one thing is true about government and the economy, it is that this always happens. Sooner or later, markets take a tumble because human beings have a tendency to invest and spend like there’s no tomorrow. And tomorrow seems to show up on our doorsteps every morning, without fail.

  But recessions can also come from policy:

• Cuts in government spending: President Richard Nixon managed to get Congress to balance the federal budget in 1969, and soon after we had a recession. Do the math: Cutting government spending will reduce aggregate demand. One of the challenges we have faced in the Great Recession is that cuts in government spending, particularly among cash-strapped states and cities, has meant a lot of jobs lost and softer overall demand in the economy. So even as the private sector slowly grows, those gains tend to be offset by losses in the public sector. Economic slowdowns also followed cuts in government spending at the close of World War I and World War II.
• Tight monetary policy: As we’ve already seen, cranking up interest rates in the early 1980s led to a very steep recession as the housing sector crashed and burned.
• Natural disasters: Storms and earthquakes can so devastate an area that its economy suffers. The twin hammers of Hurricane Katrina and the BP oil spill did no favors for the Gulf Coast region of the United States. At various points in human history, earthquakes and volcanic eruptions have set back the cause of human progress by centuries. An enormous eruption of a volcano in what is now Indonesia around the year 1xxx produced years of year-round winter-like conditions around the world, leading some scholars to say that it delayed the Europe’s recovery from the Dark Ages by 100 years or more. Not every disaster leads to an economic downturn, however. The 9/11 terrorist attacks, epic tragedies though they were, didn’t cause the recession of 2001, as the economy already was turning south before the attacks occurred.

The Great Depression

A question that often comes up, and one that people still debate, is what caused the Great Depression? The truth seems to be that it was a perfect storm of economic inevitability and bad policy, with no single cause the likely villain (despite the claims of many economists that it was the factor about which they’ve just written a brilliant book).

It was triggered by the stock market crash of 1929, which points to the first culprit—a bubble in investment in automobiles and radios. Investors, enabled by lax investing rules that allowed them to borrow most of the money they were buying stocks with, bid prices on stocks up to record highs. When the market came tumbling down, a lot of private wealth was erased, and firms in those key industries began the downward spiral of the business cycle. While the economy typically had recovered quickly from downturns, this time it didn’t. President Herbert Hoover, up until that point an extremely popular politician and a very able administrator, usually gets cast as the villain of this piece, which isn’t entirely fair. As commerce secretary in the 1920, Hoover had written a paper after the recession of 1921 suggesting that next time, the nation needed to engage in spending on infrastructure to jump the start the economy. As president during the outset of the Depression, Hoover got Congress to set a number of programs in motion, including the Reconstruction Finance Corporation, which loaned money to banks, railroads and other businesses to keep them afloat, and also pushed through bills to raise infrastructure spending.

But as the election of 1932 drew near, Hoover’s opponent was shaping up to be Franklin Roosevelt. As governor of New York, FDR had done nothing to reign in the excesses of the New York Stock Exchange, but had “that vision thing,” as the elder George Bush once said derisively of Ronald Reagan. FDR had the ability to make people feel good about themselves, and with unemployment climbing north of 20 percent, people wanted something positive. FDR offered a rather vague set of hopes and promises to get the economy going again, notably campaigning against what he called “irresponsible Republican budget deficits.” Hoover, too, wasn’t entirely comfortable with a budget deficit, and also worried that too much aid would make people too dependent on the government. (At this time, there was no welfare, no unemployment insurance—nothing except private charity, which was quickly overwhelmed by the sheer volume of unemployed Americans.) So Hoover got Congress to rein in spending, eliminating any stimulus effect of the added federal spending.

Roosevelt won the 1932 election in a landslide. He initiated a number of programs designed to put people back to work, but until the late 1930s, he pushed to get Congress to keep the budget balanced. He didn’t always succeed, but the stimulus effect of Roosevelt’s New Deal was always very small. In fact, in 1936, Congress cut spending so much that the economy fell further and faster than it had in 1929–1930.

Even then, the economy might have recovered sooner. On top of the cyclical downturn and tight fiscal policy, in the early 1930s, the Federal Reserve tightened the money supply to prevent an outflow of gold from U.S. reserves. So at the precise moment when the Fed should have been making sure the money supply was growing, they jacked up interest rates. That cut off borrowing and made recovery even more difficult.Monetarist guru and Nobel-prize winner Milton Friedman, and, to a lesser extent, current Fed Chairman Ben Bernanke, have argued that monetary policy was the sole cause of the Depression. Other scholars, such as Peter Temin, have argued that in fact the downturns Friedman and Bernanke point to occurred largely before the Fed tightened up credit markets. What seems likely true is that in the realm of policy, almost nothing anybody did was right, and that’s why the Depression lasted so long.

Some conservatives have blamed both FDR and workers for the Depression. Some of FDR’s policy initiatives, such as the National Recovery Administration, were pretty bizarre. As one political scientist noted, FDR “proposed to save capitalism by ending it.” (The NRA created industry cartels which effectively would have ended most competition. The U.S. Supreme Court threw it—and its farm cousin, the Agricultural Adjustment Administration—out on its posterior.) They have also argued that if only workers had reduced their demands for higher wages, wages would have fallen enough that firms would have been able to afford to rehire. There are a couple of problems with this analysis. First, wages fells throughout the 1930s, except for those of CEOs, and second, the NRA and the AAA didn’t last much more than a year. And, as we’ve previously observed, firms don’t borrow, invest, or hire unless somebody’s buying. And that doesn’t describe the Great Depression.

What is true is that World War II ended the Great Depression. It forced government to borrow and spend a lot of money, which put people back to work. The budget deficit grew temporarily, but given a chance to catch its breath, the economy surged toward a general expansion that lasted into the 1970s. The British economist John Maynard Keynes had tried to tell Roosevelt this at a meeting the 1930s, but Roosevelt, like Hoover and a lot of people of that era, were prisoners of their own times. Budget deficits just seemed like a bad idea. Keynes later described FDR as having “a first-rate personality and a third-rate mind.” Roosevelt, nonetheless, came off as the hero of the Great Depression, despite having done not much more than Hoover to fix it. But the changes that occurred in this era—such as Social Security, minimum wage and maximum hour laws, the right to unionize, and a lot more regulation—are with us still.

Fixing Recessions

So, we might ask, what ends recessions? Well, in the simplest terms, it’s the causes of recessions, operating in reverse.

The business cycle, left to its own, eventually will turn upward. One of the keys here, and an important economic indicator, is inventories. When the cycle is turning down, firms don’t order as much new product because sales are falling. Firms often are a little behind the curve on knowing how things are going, so that rising inventories often are a sign of coming trouble. So, when inventories start to fall, that’s a potentially good sign. Even in a deep recession, sales don’t go away entirely. Eventually, firms begin to burn through their inventories and have to place new orders. The businesses that supply them now have more work to do, which means more work for their suppliers, and so on. Slowly, the cycle begins to turn upward. Firms hire workers to meet rising demand; those workers now have more money and they go out and spend some of it pushing demand even higher. Meanwhile, in one of the great perversities of economics, recessions turn out to be somewhat good for the economy (although bad for people). Like a forest fire, the deadwood gets cleared out and new growth occurs. Some firms fail during recessions, but those are the firms that weren’t as good as the ones that survive. Surviving firms, usually by a combination of learning how to do things more efficiently and by forcing their remaining employees to work harder, become more productive and eventually more profitable. As some of that profit trickles down to employees, they get a little more money and spend a little more money and the upward spiral gets a little more steam.

And that’s what eventually happens in the economy, other things being equal, as economists so often say. Here’s the catch: This is what happens in the long run. As Keynes famously said, in the long run we’re all dead. Most people and their governments don’t want to wait for economic theory to be proven true. They want economic recovery sooner rather than later; daddy’s tired of Hamburger Helper and baby needs a new pair of shoes. So, more often than not, governments take action to counteract a recession:

Fiscal policy: Since the Great Depression, with the advent of welfare and unemployment compensation, when people lose their jobs, they get some help. That keeps total demand from falling as far as it did in the Great Depression. These kinds of programs are sometimes called automatic stabilizers, because spending on them pretty much kicks in as people lose their jobs. So recessions tend to be softer than they would be otherwise.

As we noted above, governments can also engage in added spending to try to boost the economy, such as President Obama’s stimulus package, which gave money to states and local governments, including money for infrastructure projects such as roads and bridges. Republicans who would prefer to see someone else in the White House loudly tagged it as the “failed” stimulus package, but the truth is that the economy would have done much worse without it. Liberal critics of the president, such as Nobel Prize-winning economist Paul Krugman, have argued that the only problem with the stimulus program (as with Franklin Roosevelt’s), is that it wasn’t big enough. One thing that we might conclude about fiscal stimulus is that the more it contributes to gains in productivity, the better it will be for the economy in the long run. So spending on infrastructure, education and training, and small business support, will generally produce more economic gains than would just, say, dropping cash out of an airplane.

The other part of fiscal policy is taxes, and here again, governments can use tax policy to encourage economic recovery. They can give tax credits and tax breaks for certain kinds of activities, such as hiring more workers or spending on equipment (capital goods, in the parlance of business and finance). Also common are simple tax cuts—cut people’s taxes, so they have more money in their pockets. As we also noted above, tax cuts don’t have a great track record for stimulating the economy. As with cheap interest rates, firms still don’t hire more workers unless they see rising demand for their products and services. So tax breaks may also not help in that regard. The Bush and Obama tax cuts may not have worked because at that time, people seem to have used the extra money for saving rather than spending and investing. People either saved the money or paid down their debt. Neither of those is bad for the economy (in fact they’re good in the long run), but it won’t produce much short-term stimulus. It won’t boost total demand.

Monetary policy: Here again, while tight monetary policy (higher interest rates) can cool things down, cheaper money can heat things up. Lower interest rates spurred the housing industry in the 1980s, leading the U.S. out of that recession. The same thing happened in the early 1990s. But, as we’ve already noted, there has to be some level of demand already in the economy for lower interest rates to encourage people to borrow. Interest rates remained low throughout the Great Recession of 2007 and its aftermath, but neither consumers nor businesses went out of their way to borrow. The Federal Reserve, trying to ensure sufficient liquidity (ready cash) in capital markets, made sure that major banks had as much money as they could want at their disposal, and microscopic interest rates. But despite all that cash floating around, people and businesses didn’t want to borrow. Consumers, fearing for their jobs (or without them) didn’t want to take on more debt. With soft demand, businesses had no reason to borrow for expansion.

The final solution would be to wait things out and let the market sort through what’s wrong with the economy. Under this scenario, workers would cut their wage demands until it became profitable to hire them again, and the economy would then begin to turn around. This seems to have worked in the past, although it clearly didn’t happen in the Great Depression. So it’s not clear how workable this solution is in the current age, when most of us can’t go back to the farm and at least feed ourselves while we’re waiting for the economy to turn around.