Most people would agree that recessions are terrible things. They cause widespread fear among people making them anxious about their savings, their livelihood or even their next meal.
Recessions are akin to natural disasters. They do massive damage, but for the most part are widely accepted by society as an inevitability rather than a rarity.
But do we actually need recessions?
The takeaway here is that this is a man-made issue that should be entirely possible to undo with the same kind of man-made response. To add to this, for most of human history, we didn’t really experience economic recessions as we know them today; even in societies with very complex economic systems, we saw good times and bad times for sure, but that (the bad times) was almost always the result of something tangible like wars or droughts or other natural events. The few purely economic downturns that did exist outside of these, were extremely few and far between.
So this brings out the question of do we actually need these recessions? To properly explore the main question, we need to break down the question into a few key parts.
What is a recession other than being two consecutive quarters of negative growth? Why have they become so prevalent? And are they actually that bad? If we can find ways to answering these questions, we may not have to take any of these mysterious economic events for granted ever again.
What is a Recession, Technically?
Technically and simply stated, a recession is two quarters of negative growth. At least this is how we measure a recession, but the two quarters of negative growth is more of a symptom of a recession rather than being its true underlying cause.
Things that cause recessions basically come in two flavors; demand shocks and supply shocks.
Supply Side Recessions
The supplier side recessions are probably the easiest to understand. Let’s take a relatively small hypothetical island nation as an example of small economy, and say that their Industries are made up of farming, fishing and tourism primarily. Now, let’s say that a massive hurricane has hit this little hypothetical nation, completely wrecking its fishing fleet, flooding its farm lands and partially destroying its lovely hotels. Well, obviously this nation is not going to be able to produce output (products and services). And if it takes more than two quarters to recover and get back up to speed on everything… In this case, by definition, this hypothetical nation is going into a recession.
These are the types of recessions that we tend to see throughout history. But in reality, they would actually be called something else, something like a famine or a tragedy…
This is an example of a supply-side recession, where external events have massively decreased the ability of the nation to provide goods and services (supply side), and since growth is measured in GDP, and GDP is the consumption of goods and services where there are none to consume, therefore a recession was formed. In reality, these types of recessions are rare these days, especially if you look at a nation like the United States, where it is unlikely that any kind of normal natural disaster is going to have enough of an impact to single-handedly push the whole nation into a recession.
Demand Side Recessions
Demand based recessions are the ones that are far more common and difficult to understand. At their most foundational level, demand based economic recessions are just people choosing not to consume as much, not because there isn’t as much to consume, but simply because there are forces at play that dictate so.
Consumer confidence is a big determinant of this; if people are unsure if they are going to have jobs in the future or if their hourly wages have already been cut, they are going to be less likely to spend what money they do have on unnecessary goods or services. Instead, they will just hold on to their money to make sure they will have enough if they do end up losing their jobs in order to be able to pay for their vital needs and essentials. Again, since growth is measured in GDP, and GDP is a function of consumption, then less consumption means less GDP and less growth. So if this kind of more conservative consumer spending goes on for more than two quarters, then we have got ourselves a recession.
The Age of Excess
So, the question becomes, why do these sort of events happen so frequently these days and why didn’t they happen that much before?
Around the turn of the previous century, there was a fundamental shift in a select few nations, especially the United States. The Great War was over and the age of mechanization had begun. Machines were being utilized for all areas of production feeding more the supply chain.
For the first time in history mankind was no longer constrained by how much it could produce but rather by how much the producer could convince people to buy. In the past, farms and basic factories were desperately trying to keep up with the needs of the people. If we think about our reality today, we will see that we waste tremendous amounts of food and probably not really producing as much stuff as we could if we had an endless customer base.
Taking the automaker Ford for example, they produce around 7 million cars a year, but if they really wanted to, they could easily produce 20 million. The only thing that stops them from doing so, is that the demand for Ford cars is 7 million a year. Ford won’t produce any more, because that would be a horrendous waste of money to make all that inventory that they are then going to store or sell-off at a massive discount. The consumers’ ability to consume has become the bottleneck in a modern global economy.
How much consumer can consume is a long-term function of two things; how much they earn and how much they want to spend.
If people earn more money, it stands to reason that they will be able to buy more stuff, and if they spend a larger portion of their money, it will also stand to reason that they will be able to buy more stuff.
During good economic periods, lower unemployment, means that people can demand higher wages because employees are hard to find or persuade to come. Therefore, employees will have more money in hand and will be willing to spend a little more because they fall into the trap of thinking that these good times will go on forever. This all gets even more interesting when taking debt into consideration. The main rule is that debt has to be paid back. The actual effects of debt are relatively minor over a long enough time period in most cases. It’s really in the short and medium term that debt is particularly influential, that is because it can give consumers a massive boost to their consumptive power.
Back to the Ford automaker example, most people will struggle to pay for a car in cash. However, if they were offered car loans, they will be able to get into their brand new Ford for a small monthly payment over the next 120 or 180 months. On a larger scale, debt means that more people will be able to buy more houses, cars and even boats or attend fancy dinners. In other words, more demand, higher consumption of goods and services, growth in GDP and a high living standard based on debts.
The problem will arise the next year, when the newer model of Ford comes out and most people won’t be able to buy it because they still have two years left on their loan and they’re trying to save some extra cash to pay down their other debts and debit cards.
Demand based economic downturns can be caused by anything that scares consumers, but the thing that scares consumers most is debt and knowing that they need to find some way to pay for yesterday.
Is there another Way Around?
In brief, most recessions happen today because people living in modern developed nations are high demanders (spoiled consumers) that get scared by their own excess. They have more than they know what to do with, and allow themselves to living beyond their means and most importantly regret it later when the bills arrive. Most economists are well and truly on top of this reality and have come to accept it.
But is there an alternative? Well, the answer is partially yes. Some systems have been implemented to alleviate these dramatic ups and downs. They are counter-cyclical fiscal and counter-cyclical monetary policies.
A recent example is that amid and post the Corona pandemic (at least the first wave so far), nations started giving out huge stimulus checks to everybody while dropping interest rates, all in an attempt to boost economic activity to counteract the effects of this global economic crisis. But at the same time, these stimuli are more of a band aid solution to the issue rather than actually something that stops them.
Many economists argue that recessions are actually the sign of a healthy economy. At least in the long term, recessions are an effective way for economies to sort out their issues and focus on good labor. They are in a way the economic equivalent of cutting off the fat which is seen most prominently in employment.
It is true that one of the greatest casualties of a recession is employment especially when you start picturing people lined up outside job centers or welfare offices. But this gloomy picture has some underlying advantages. When lots of people lose their jobs, they will start searching for new jobs, which is great for the businesses that are still operating during a recession because they will be able to bring on more high-skilled staff at lower prices. In theory, this means that businesses that are hiring may be able to bring hire for example a Harvard MBA as a junior analyst for a lower wage who (in theory again) should excel in his/her role making the business more efficient and able to produce more output at lower cost. On the long term, businesses will save more money, make profits and be able to grow. On a macro scale, this scenario will be reflected positively on the economy.
The opposite is also true. If we are in an economy approaching full employment and a company is looking to hire a new senior manager. It will very quickly find that it’s very hard to fill this position. Everybody who is qualified will already be working and perhaps the only option the company will have is to attract someone who is already employed to come over to the company by offering him/her a higher salary. This means that the company will just have to pass this extra cost along to their consumers as more expensive goods/services therefore causing inflation.
From here comes the term NAIRU which stands for “Non-Accelerating Inflation Rate of Unemployment”. The same thing is true for lots of things in an economic boom, not just employment. This is one of the key drawbacks of sustain prosperity when things just get very expensive, which means that people’s actual quality of life is not improving even though GDP figures look healthy.
Recessions are not a necessity, but they do serve a purpose in the same way that nobody really enjoys an intense workout or a diet plan. Sometimes a bit of short-term pain is worthwhile for a more sustained long-term benefit. The idea that a recession will help reallocate resources and assist with long-term economic growth may provide little comfort to those that have lost their jobs or their business or their retirement savings.
The reason recessions didn’t happen that frequently in the past is not because people back then were better economic managers or even because they were more responsible with debt. It’s just that they weren’t on the same rocket ship of growth that we are on today.