What Causes Recessions?
What Causes Recessions?
Article first published online: 11 OCT 2012
© 2012 The Author. Economic Affairs © 2012 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford
Special Issue: Student and Teacher Supplement
Volume 32, Issue Supplement S3, page 4, Autumn 2012
How to Cite
Wellings, R. (2012), What Causes Recessions?. Economic Affairs, 32: 4. doi: 10.1111/j.1468-0270.2012.02191_3.x
- Issue published online: 11 OCT 2012
- Article first published online: 11 OCT 2012
In his last budget as Chancellor, Gordon Brown said ‘we will never return to the old boom and bust’. At the time it was hoped that better management would reduce economic volatility. But just three years later the UK had entered a prolonged slump.
Recessions have occurred throughout recorded history and it was perhaps naive to expect that policymakers could prevent them. They are defined as a period of falling output and are typically characterised by high unemployment, a rise in business failures and a drop in the standard of living.
This contrasts markedly with the normal progress of market economies. Driven by the profit motive, entrepreneurs discover better and cheaper ways of providing goods and services – for example, by deploying new technology or developing trade links with more efficient producers. This helps explain why market economies usually grow, but not why they contract in certain periods.
Economists disagree on the most important factors causing recessions, depending on their theoretical approach. There is to some extent a shared focus, however, on the causes of the mismatch between production and demand. During recessions, large numbers of producers struggle to sell their goods, at least at prices high enough to generate a profit. Some of them go out of business, while others shrink their activities to cut costs. This has a knock-on effect across the whole economy as people lose their jobs and make losses on their investments. In this way, problems in one sector, such as housing and construction, can spread to others such as retail.
Entrepreneurs often make mistakes, of course. Many products take several years to develop and by the time they are put on to the market, consumer preferences may have changed. Market prices constantly transmit information about the products consumers want, so at least in market economies there is a feedback mechanism to enable entrepreneurs to adapt to changing conditions and correct their errors. However, the boom periods that precede recessions are typically marked by entrepreneurial error on a grand scale.
Psychology may play a part here. There have been numerous ‘manias’ throughout history when over-optimistic investors piled into particular sectors, from the ‘South Sea Bubble’ of the early 1700s, to the ‘Railway Mania’ of the 1840s and the ‘Dot Com boom’ of the 1990s. Investors subsequently made huge losses, as projected returns failed to materialise, with negative effects on the wider economy.
Investments may fail as a result of unforeseen changes in circumstances. New technology or competition from abroad might render an industry obsolete, meaning that resources such as labour need to be redeployed. Such developments are beneficial in the longer term but lead to short-term disruption. The ‘long depression’ of the late 19th century, for example, was influenced by a decline in European agriculture as a result of competition from efficient new farms in the Americas.
Whilst shifts in trade patterns and the adoption of disruptive technologies inevitably have a significant impact on economic activity, generally their impact is too gradual or sector-specific to explain the very pronounced boom-bust cycles that are observed. The most plausible explanations for recessions therefore explain why large numbers of entrepreneurs in different sectors of the economy make bad investments at the same time.
One set of theories focuses on the role of money. When authorities such as central banks create money to stimulate the economy, this distorts investment decisions. An increase in the money supply initially tends to reduce interest rates. These lower interest rates encourage investment, particularly in long-term projects. Such projects would not be viable at higher interest rates because the repayments would be too high.
However, if increases in the money supply are too rapid, the prices of goods and services will eventually rise. Monetary authorities then seek to correct this by raising interest rates, which in turn undermines those investments that are only viable if interest rates remain low.
Theories based around the money supply and interest rates certainly seem to explain the current slump. In response to the mild recession of 2001 and the 9/11 attacks, the US Federal Reserve expanded the money supply to stimulate the economy. Interest rates dropped to very low levels, creating a boom in sectors such as housing and construction. The boom collapsed into bust as rising price inflation forced the Federal Reserve to raise interest rates. Banks reduced lending and investors realised their projects were unsustainable. The collapse of the US housing market helped trigger a wider slump in other sectors and other countries.
Such explanations for recessions suggest policymakers should be cautious in how they respond to economic contractions. By expanding the money supply to boost the economy, the authorities may be sowing the seeds of the next downturn. The causes of recessions are, however, complex and no single theory draws together all the different factors at work. So, the next time someone claims to have abolished boom and bust, the claim should be treated with scepticism.