In praise of recessions

Parenting is simple, but not easy.

What I mean by that statement is that it’s not hard to figure out what to do as a parent (simple), but it’s frequently difficult to implement in practice (not easy).

Little Vivian wants a glass of apple juice, but it’s an hour and a half before dinner and she’d prefer to drink apple juice 24/7 rather than eat any solid food–ever! 

I have a choice: I can give her the apple juice she so much desires and worry she won’t eat the food she needs, or I can give her some non-apple-juice options to make sure she’ll be hungry for dinner.

It’s easy to give her the apple juice, right?  But, will it result in the long run outcome I want?  Probably not.  So, I offer her water and tell her she doesn’t want to ruin her appetite for dinner.

The first several times I provide this option, Vivian–like any self-respecting 3-year-old– breaks down in tears.  Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you’ve ever seen (not easy).

I know the right option (simple), but I dread the implementation (not easy). 

After 3 iterations of this process, though, Vivian no longer breaks down and cries.  She expects this outcome and goes about her life quite happily knowing she can’t have what she wants whenever she wants it.

And so it is with the economy, too.  Knowing human nature, it’s easy to see that people take things to excesses at times.  Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren’t necessarily best for their long term well-being.

Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do.  Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.

It’s easy to understand this process is necessary, assuming you understand human tendencies (simple), but it’s unpleasant (not easy) to watch the resulting pain inflicted.

I’m not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears.  But, I must consider the alternative.

If we try to prevent recessions, is the long term outcome better or worse?  Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems.  And, so it is with recessions.

Preventing recessions leads to a build-up of bigger and bigger problems.  Periodic purges prevent major disastrous purges.  If you don’t believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan’s lost decade.

In each case, political intervention was intended to keep the economy on stable footing.  The hope was to prevent short-term pain, but with little regard for long term consequences.

I think an analogy to nature here is useful.  A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan’s Ubiquity for more information).

At first, experts were bewildered at the damage and what could have caused it.  Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable. 

In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn’t have even been possible without preventing small fires.

I believe the same thing is at work in the economy.  Small periodic recessions are good for purging the under-growth of our economic forest.  Without such small recessions, a super-critical state is created.  The attempt to prevent small recessions is the cause of large, disastrous ones. 

And so, I praise small periodic recessions as the necessary prevention for big, terrible ones.  It’s time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary. 

It’s time for the parents to say no to the kids who want something that’s bad for their long term well-being.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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In praise of recessions

Pushing on a string?

If you’ve ever water-skied, you know you must keep slack out of the line to stay on your feet.  If the line loosens, you have little time to take out the slack or you’ll be swimming.

The Federal Reserve, too, must keep the line tight.  Otherwise, it finds itself pushing on a string.  And, as any water skier knows, pushing on the string is of little use.

Why is the Fed pushing on a string?  Because it–like a boy with a hammer–has only one tool at it’s disposal: creating money out of thin air.

When the economy slackens, the Fed reduces interest rates (by printing or threatening to print money).  This is supposed to encourage borrowers to borrow, thus increasing economic activity.  As long as borrowers think they will get higher returns on the money they borrow than the interest rate they owe, they’ll borrow. 

But, a problem occurs if borrowers either can’t or don’t think they can get good enough returns on the money they borrow.  When that happens, the Fed can lower rates and print money all they want and the economy won’t improve.  That’s when the Fed finds itself pushing on a string.

There are serious questions about the U.S. economy being at this point.  Very smart people are concerned the Fed can’t get the economy going again, and they have powerful historic examples like the Great Depression and Japan to support their thesis.

During the Great Depression, the U.S. experienced a huge drop in economic activity, high and sustained unemployment, and significant deflation. Shrinking money supply was one of the things blamed, and so most economists have taken that as the solution to a similarly deflationary scenario like now.

Japan has been in a 20 year on-again/off-again recession.  Over this time, its stock market is down 75% and its economy hasn’t grown.  Its central bank, like the Federal Reserve, has tried lowering interest rates and quantitative easing (a euphemism for printing money).  These solutions have kept unemployment from spiking, but have done nothing to improve economic growth and have left the Japanese government with a huge load of debt.

I think these two examples are important in understanding our present situation, but most analysts and commentators miss the point.  I do think the Fed is pushing on a string, but not for the reason that most suggest.

Borrowers will only borrow if they think they can get good returns on capital.  Such lending will only be effective if positive returns on capital are earned.  For the economy to grow and standards of living to improve, you need positive returns on capital. 

The issue is not employment, nor printing money, nor interest rates, nor fiscal stimulus.  The issue is positive returns on capital.  Without that, there is no growth, only decline.

The U.S. government tried all sorts of things during the Great Depression to improve employment and get the economy going (both Hoover and Roosevelt).  The result: the worst economic decade in U.S. history.  The U.S. economy finally started growing again during World War II.  Was that because killing people and destroying property is growth?  NO!!!  It’s because the government boondoggles finally ended and individuals were able to get positive returns on capital.

Japan will not improve until positive returns on capital becomes its focus.  As long as employment and consumer demand are the focus, Japan will not grow.  Only when the Japanese economy refocuses on generating positive returns on capital will it grow again.

The same is true here in the U.S.  Printing money, lowering interest rates, giving loans to negative return on capital projects, and creating boondoggle employment will not create growth. 

The Fed is pushing on a string, but that’s because it doesn’t understand where growth comes from.  It doesn’t come from creating money or lending, it comes from positive returns on capital, and there’s nothing the Fed can do to bring that about. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Pushing on a string?