Recession, Part 1 of 2

This will be the first in a short series of posts (maybe 3, maybe 2, not really sure how long it's going to take) on the current economic situation. Today, we'll look generally at what a recession is, what causes one, and how this applies to the current slowdown we're experiencing. You will also get a general sense of how big of a loser I am.

The headlines are everywhere: there's a good chance the economy is either in a recession or rapidly headed towards one. After 6 years of decent growth, the economy is losing jobs.

I'm proud to say this blog mentioned the possibility of a recession around a year and a half ago, and I agree that we're in some form of a recession now and may be for the next few months. But it is necessary to explain what a recession is, how we got in one, and what, if anything, could be done to avoid another one in the future.

I. Just what IS a Recession?

The word gets thrown around loosely in newspapers, although very few people know how to actually define what it is. And to determine just what a recession truly is, we must also determine what causes a recession in the first place.

The textbook definition of the word is when the nation's gross domestic product fails to grow for at least two consecutive quarters. In other words, when the total value of all goods and services bought and sold shrinks during a 6 month period, the nation has technically experienced a recession. But this definition is flawed in that it's directed more to the effects of the recession instead of its actual causes. Sure, the economy contracted for 2 straight quarters, but how? Why? What made this happen? What causes this sudden downturn in business activity? If we break these things down we can better understand why we're in a slowdown and what, if anything, can be done about it.

II. A Two-part Process

The way I see it, a recession can best be viewed of as a two-part, cause and effect, process:

1. MALINVESTMENT: A situation where firms and their investors collectively make bad economic decisions by pouring $ into projects that originally looked profitable, but turned out not to be.

2. LIQUIDATION: The negative effects are felt as the bad investments must be "cleansed." A cluster of errors is revealed as balance sheets turn from green to red and firms are forced to cut production and layoff workers. These layoffs of course translate into lower incomes for workers and their families, which means people have less money to spend, which can translate into further layoffs in industries that produce consumer goods, and the ripples disseminate further.

So in essence, a recession is an inevitable transitionary period during which investors and businesses pull their $ out of bad investments so it can be returned it to truly sound and profitable ones.

But there is still more to this. To be sure, in a free-market economy, bad investment decisions are made all the time. Business go under, risks are undertaken and many fail (this, of course, is why the are called risks). But a crucial question to ask is just how could so many bad investments have been made all at the same time? Is it just a mere coincidence that, every 8-10 years or so, millions of businesses across the country all happen to get it wrong simultaneously?

The reality is we experience what is known as the business cycle. The reason (and blame) for this cycle and the recessions it creates lies not with any inherent failings of free-market capitalism, but instead with the Federal Reserve Board's ability to lower interest rates, which sends a false signal throughout the economy.

III. How the Fed Causes the Business Cycle

Interest rates are determined by the supply and demand of loanable funds. In other words, when people are saving more, banks have more deposits, making rates low. When people are borrowing more and saving less, banks don't have as many deposits and rates are higher. So the "price" of a loan is simply determined by the supply of and demand for savings. Makes perfect sense, right? But here's the kicker, and this is key to understand: the Fed is able to step in and manipulate interest rates by printing new money out of thin air and injecting it into banks. This lowers the interest rate (at least in the short term) and induces investment and economic activity that otherwise would not take place.

The Fed did this in the wake of the dot-com bubble burst at the end of the 90's to "soften the blow" from the previous recession. Between 2001 and 2004, the Fed's printing presses were in full gear as Greenspan lowered rates to unprecedented lows. This induced all kinds of economic decisions that would have otherwise never taken place: Home buyers took advantage of ridiculously cheap mortgages. People that usually wouldn't have been able to afford a home used interest-only, no money down financing and bought up new houses like they were going out of style. As home prices skyrocketed, homebuilders ramped up production to fill a seemingly insatiable demand for new inventory. Mortgage companies, banks, brokers, contractors, and anyone involved in the housing sector hired millions of new workers to keep up with the boom. Basically, tons of resources (money, land, people) were allocated toward a sector that looked in, say, 2003 or 2004, to be insanely profitable.

Unfortunately, there comes a point where the Fed realizes it cannot keep these "artificially" low rates down forever: by continuing to print more and more dollars, the economy inevitably begins to experience the worst of all economic evils: inflation. The nature of inflation and its harmful effects are for another post, but suffice it to say that the Fed realizes it cannot go on creating money out of thin air and has to eventually allow rates to rise back up to their natural market level. This is what happened between 2005 and 2007.

IV. Concluding Thoughts, For Now

So you can think of the Fed's lowering of interest rates and the inflationary boom it creates like drinking alcohol or caffeine: the good effects are felt immediately, while the bad effects come later. Like Snuffy on St. Patrick's Day, inflation of the money supply creates a period where no pain is felt and you do lots of things you otherwise wouldn't have in a normal setting. But, as we all know, these good times are short-lived, and a hangover is inevitable. This is where we'll pick up next time. Class is dismissed for now.