Tuesday, May 22, 2007

What Causes Economic Recessions?

Based on a Google search concerning this issue it appears that this is a tough problem for professional economist as well. In a brief article published by the Federal Reserve Bank of Boston (FRBB) written almost 10 years:

. . . . what causes economic downturns is still a largely unsolved puzzle. The traditional explanation is that recessions are caused by events that have an economy-wide impact, such as an increase in interest rates or a decline in consumer confidence. Firms reduce output and lay off workers, which further decreases demand, and the economy slows even more.

But, some firms add staff during recessions, even as others are reducing their workforce. So some economists have suggested that recessions might be caused not by economy-wide changes, but by events that hurt particular firms or industries. They speculate, for example, that a major innovation or a change in the price of a key input can adversely affect some firms, causing them to reduce production and discharge workers, while other firms are helped and seek additional workers. Since it takes time for displaced workers to find jobs with new employers, a recession may occur during this period of "reallocation."

The recessions that followed the dramatic increases in the price of oil in 1973 and 1979 were due, at least in part, to such changes. Businesses for which demand was sensitive to energy prices, such as full-sized cars, suffered a sharp decrease in orders and were especially likely to contract. Those that required a lot of energy to run machinery faced higher-than-typical cost increases and were also more likely to reduce output and staff. It took time for displaced workers and other resources to be reemployed elsewhere. In the meantime, the economy experienced a recession. further decreases demand, and the economy slows even more.

This is similar to comments made by Joe Ellis in his book Ahead of the Curve, where he more pragmatically uses real hourly wages of production workers to predict a recession. If corporations layoff workers wages will decline, thereby further decreasing demand.

The authors of the FRBB article further state further that:

Most recessions involve a tangle of forces. The 1970s' oil shocks also set off an economy-wide decline in demand as real income was reduced by the higher cost of oil imports and tighter monetary policy dampened the inflationary pressures which followed the price increases. These factors slowed overall demand, and so were also partly to blame for the subsequent recessions. And, such a drop in demand may cause further job destruction. Thus, aggregate forces can play an important — perhaps even a dominant — role in recessions, even if allocative forces provide the trigger.

Yet, paying attention to forces that can produce reallocation may help us spot the seeds of future slowdowns and bursts of growth.

A good point in this discussion is something that I always thought, but have not been able to prove which is that for an economic recession to develop the economy needs a catalyst to “push it over the edge”. The recessions of the 1970s and 1980s had high oil prices that caused significant reallocation of workers as stated above and the recession in early 2001 had the decline in the number of computer people needed to handle Y2K.

The $64,000 (estimated to be $452,399 in today’s dollars) question is: What is the significant force in today’s economy that could cause a recession. Is it the continuing unemployment in the construction industry due to the decline in housing? Is it the unemployment that will eventually occur in the finance industry due to the decline in housing? Is it the inability of the consumer with high levels of debt to continue spending due to restricted cash flow? Is the spending squeeze that consumers will feel as the price of energy increases? Or are we witnessing the development of the Perfect Storm because it is the combination of all these issues.

At this point one can only speculate.

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