Don’t worry. Let it all go. Recessions are self-correcting..

By a certain John Tammy, writing for Forbes:

• Recessions Are Self-Correcting

Is there something in this? Well, in a way, yes. There are self-correcting mechanisms in markets. When things go bad, there is an excess supply of resources (like labour), and this exerts a downward pressure on their price which, at some point, will be low enough to reduce supply and increase demand and clear the market (equate supply and demand) again.

However,

• What works in individual markets does not necessary work for the economy as a whole (the famous fallacy of composition), like the savings paradox. (Under balance sheet duress, saving is rational for the individual, but produces perverse outcomes when everybody does it)
• This is no ordinary recession; there are self-reinforcing feedback loops at work,

Let’s describe a few to give you an idea (we’ve done this earlier, but anyway):

• Cheaper labour means reduced spending, which tends to reduce production even more
• Over-extended and over-leveraged balance sheets, leading to an increase of bad assets, which leads to reduction in spending (and production), leading to forced asset selling and a curtailment in credit supply, leading to even more forced asset selling, lower asset prices, even bigger balance sheet problems (and increased savings, reduced spending and production, etc. etc.)
• The latter spills into bank failures (which started to happen last year), which exert even more downward pressure on asset prices, hence forces more people and companies into balance sheet problems, leading to more forces asset selling, increased savings and reduced spending, and hence reduced production, reinforcing it all once again..
• And there are powerful mechanisms to spread the misery abroad, as we can witness on a daily basis, with whole economies collapsing, making it difficult for countries in trouble to export their way out

The latter usually goes something like this:

• Country pursues stable exchange rate to slay inflationary expectations
• To defend it’s currency, it needs higher interest rates then abroad
• With lower interest rates abroad and a supposedly stable exchange rate, companies and households start to borrow in foreign currencies. This has happened on a massive scale in Asia in the early 1990s, and even more so on the fringe of Europe and Russia today (and happens with regularity in Latin America).
• The currency becomes overvalued through the inflow of foreign capital, leading to doubts about the fixed rates, leading to speculation against them, and, more often than not, ultimately to a large fall in the currency
• This drastically increases the domestic currency value of the accumulated foreign debt, leading to instant insolvency of many companies and households, and ultimately banks. This is what happened in Argentina (2001) Iceland (2008), Ireland (2008-9), much of East Europe (2008-9), Russia (2008-9), etc. etc.

All this reinforces a global slump, which might get much worse when prices (the supposedly equilibrium restoring mechanism of markets) start to fall. When that happens:

• Real interest rates will rise, because nominal rates cannot fall below zero
• Balance sheet problems will become even worse, as the real value of debt will balloon.

And then, we are in real trouble as the way out of such a deflationary spiral is, well, very difficult (only massive money creation and public spending can stop the rot).

And while most of this is playing out as we speak, the market fundamentalists who claim we should do nothing (and who bear most of the blame in creating this crisis in the first place) would have been happy to:

• Let most of the banking system go bankrupt. From the demise of Lehman brothers we have already seen what a complete chaos even the demise of a single institution has created (the whole interbank market came to a grinding halt as no bank trusted any other, leading to soaring interest rates even in the middle of a steep recession and a freeze in credit). Let alone if most of the banking system would go, things would become unimaginably bad..
• Let GM, Chrysler, etc. etc. go, destroying a good part of the industrial base (as well as much of the financial sector, two important pillars of the US economy)
• The magnitude of the crisis would lead to the Federal budget spiralling out of control even without any policy initiatives, as tax receipts would dwindle.

But hey, in the long-run, things would turn around. As Keynes used to say, in the long-run, we’re all dead.