Friday, November 29, 2013

What is a recession, and why do we care?

Imagine a large group of people (perhaps it would be better to consider groups of peoples) on a quest to conquer a very large, uninhabited continent. By "conquer" I mean they seek to live on this land and improve their lives and the lives of their progeny. We can call that the goal, but it is important to understand that there is no singular goal. There are many, many goals, and within each goal are numerous sub-goals. To measure success toward this generic goal there are two important qualities:

  • How much people advance toward their goals
  • How efficiently people advance as they attempt to advance

The first quality is about increasing resources while the second is about maximizing the use of existing resources. Doing better at one can come at the expense of the other (a zero-sum game), but it can also come to the improvement of the other (a positive-sum game). The political-economic system that governs will determine which game conditions will exist.

To hone in on the concepts I am exploring, let us consider the early days of exploration of this new, raw continent. Let us further consider the macroeconomist to be the omnipotent (but certainly not omniscient) expedition leader. The process of moving across the continent is a constant process of trial and error. At times this becomes a seemingly coordinated activity whereby many errors or successes occur at the same time. At these times it is more of a surge/retreat process. This is akin to the so-called business cycle of modern macroeconomic parlance.  But why do we seem to get surges and retreats—that is massive, similar results at the same time where the magnitude makes it "clear" this is something happening not just to me or my small group but to "all" of us at the same time?

In all macroeconomic models feedback is an essential contributor. All leave room (in varying degrees) for animal spirits. The different schools of thought are taking up daunting challenges. They are attempting to not just answer the questions of why is this happening and how can we stop it but also the question is it really happening.
Problem posed by the group: We’re lost and don't seem to be making good progress…
Solution offered by the macroeconomist: Are you sure you're lost, and if so, how do you know if you are or are not making good progress?
The particular school of thought from which the macroeconomist originates will determine the next steps in the solution. Here is an oversimplified summary:

  • The Keynesian seems to believe that if the group just keeps moving in any direction, they will eventually start making meaningful progress. Activity for activity’s sake with no fear (old Keynesian) or qualified fear (new Keynesian) that the induced activities will be more costly than curative.
  • The Market Monetarist seems to want to change the scale on the map. If the group is deceived about the pace being made, the group will more effectively make progress.
  • The Real-Business Cycle (RBC) adherent seems to believe that the actions of the Keynesians and Market Monetarists rather than solving the problem have in fact caused it.
  • The Patterns of Sustainable Specialization and Trade (PSST) devotee seems to say we just sometimes have to stop and recalibrate and maybe send scouts out to see if there are better paths or impassable obstacles in our way.

Leaving our allegory but still over-simplifying, recessions are when progress is not what we think it should be and to a degree of magnitude such that we give it the label (in fact I'm somewhat surprised we don't name recessions as we name hurricanes). To be certain we are constantly falling short of potential, but it is all relative. What matters is when that falling short is some combination of quite short, for quite a while, for quite a few of us, and (this is key) without quite the natural recovery we would otherwise expect (i.e., persistence, which is in the eyes of the beholder as witnessed by the extent of the macroeconomic debate). Some parting random thoughts:

  • Keynesianism seems least concerned with how we got here—it is a recession and here is how you get out of recessions. Arguments about if it is duck season or rabbit season are of no concern. If the fire is hot and your hand is burning, take your hand out of the fire. How or why the fire started is of little concern. As such it leaves the most room for magic both in problem definition as well as solution.
  • Market Monetarism seems to offer the most straight-forward solution (get monetary policy right), but it is the specific solution too few can agree on the definition of.
  • PSST seems to explain recessions as a combination of coincidence and regulatory policy error. Recessions free up resources after major disruption(s). There resources usually include labor, but can be many types of capital too. The disruption(s) can be greater-good productive (e.g., computers and medical advances) or counter productive (e.g., regulation and tsunamis). As such, PSST has the most defeatist fatalism built in to it.
  • At many times RBC seems to be a particular form of PSST in the midst of market monetarism with the fear of one particular manipulation (money-interest rates-price of credit) causing the problems.