A Primer on Our Burning Economy

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The criticism of the stimulus package has revealed something that many of us in the policy world often suspected—most people still don’t understand recessions. Sure, they understand what they are. After all, they are feeling this one far more acutely than those of us in the somewhat recession-proof D.C. metro area. But if the talking heads on cable TV and attention-seeking politicians are any indication, we economists still have a long way to go to explain why they happen.
 
Think of a recession like a fire. While recessions often have different sparks to start the flame, each continues to burn for pretty much the same reason. And like a fire, with just a little oxygen they’re self-sustaining and can spread. So once they start burning, they can continue long after you’ve extinguished the initial spark.
 
What causes recessions to continue burning? Recessions are characterized by a drop in demand followed by a fall in supply. Consumer confidence tumbles, and people spending less money. As their demand for goods and services contracts, businesses experience a loss in revenue and they have to lay off workers or, at the very least, cut their hours. These payroll adjustments reduce workers’ incomes, meaning they have less to spend, which causes consumer demand to decrease even more. A vicious cycle indeed.
 
But it’s actually worse than that. At each stage in the cycle, the effect is amplified. Business fixed investment—such as investments in buildings, equipment and technology—is notoriously sensitive to the economy. In the most recent downturn, a four percent drop in GDP corresponded to a 19 percent decline in business investment. Drops of this magnitude cause severe job losses.
 
The rise in unemployment then leads to disproportionately large declines in consumer demand. Some of this effect comes from a loss of disposable income, but most of the decline can be attributed to an erosion of economic security. With no health care and an uncertainty of when they’ll be able to find another job in a recessionary economy, recently laid-off workers will severely contract their spending.
 
This economic insecurity extends to those workers’ coworkers, friends, relatives and neighbors, who are now all wondering if they’re next on the chopping block. This is called the Paradox of Thrift: Everyone responds to the economic insecurity of a recession by being thrifty, but in the process spends less, which reduces the demand for goods and services and makes the recession much worse.
 
So the fire doesn’t just continue to burn, it grows exponentially. Some conservative policymakers (and even a few clueless economists) adopt an attitude of economic nihilism and argue that we should just let the economy burn. Hey, at some point the fire will put itself out, right? The answer is yes, but only after a lot of unnecessary damage. Luckily, responsible policymakers have used the policy equivalent of water—fiscal stimulus—to start fighting the fire.
 
(Image by Janne Karaste)
 
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