Post-Keynesian Observations

Understanding the Macroeconomy


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[NOTE: Be sure you have read part 2 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

I implied at the end of part 2 that there are forces in the economy (at least as currently designed) that create a pattern to the balance between uncertainty and animal spirits. Indeed, there are, and they are created by the fact that it is very easy to saturate demand in a modern, industrial economy.

To make things simple, consider an economy that does not trade with other countries and has no government sector. That leaves only two groups: firms and consumers. Ultimately, the latter is the source of all demand for goods and services. Firms buy things, too (from other firms), but only because output will eventually be offered to consumers. Consumers buy two sorts of things:

Non Durables: Food, gas, electricity, rent, etc.

Durables: Car, refrigerator, computer, hot-water heater, washer, dryer, stove, microwave, etc.

The demand for items in the former category is, as you might imagine, fairly stable. People may buy more sandwich meat in bad times and steak in good, but you have to eat. On the other hand, when the economy is in good shape, people buy that new car they’ve been wanting; when it heads south, they put up with a lot of repair bills. But there’s even more to it than that–the very fact that they buy the new car in good times helps create/perpetuate those good times and it hastens the arrival of the bad times. The reason is that THE DEMAND FOR CONSUMER DURABLES CAN BE SATIATED FAIRLY QUICKLY. You need food every day, regardless of how much you ate yesterday. But you don’t need a new car right after you just bought one, particularly since you’ve got that payment to make. During expansions, consumers (particularly because they’ve been putting this off during the recession) load up on durable items. Banks, being in a good mood (because of all the sales), offer great financing plans. Firms gear up production and employment and this means rising incomes. Everyone gets their new washer/dryer. But once they have it, they stop buying and the cycle reverses–with a vengance.

To reiterate, during expansions, consumer durables sales rise and this helps to propel the expansion. This encourages firms (pumping up animal spirits) and they hire more workers. Banks are happy to accommodate given how well the economy is doing. A multiplier process takes place whereby rising incomes lead to rising spending which creates more income and more spending. Happy days are here again! But, this is an unsustainable process. People will, without question, cut back on purchases of new cars, XBox360s, furniture, boats, etc. Not only do they not need a second boat, now they have that damn payment, too!

You’d think all this was pretty obvious and that firms would be on the look out for it. A curious thing happens, however, and it seems to repeat itself time after time after time. During the run up, animal spirits go sky high. Consumers, entrepreneurs, bankers, policy makers, butchers, bakers, candlestick makers–all of them–become far too optimistic about the future. They start to think that this can go on forever (remember the talk of the “New Economy” back in the 1990s?). And so, as animal spirits are going higher and higher, the real prospects of further sales are actually going in the opposite direction. Not good in a world where people really don’t have a firm grasp of what the future holds (recall Keynes’ concept of uncertainty) and thus can easily be panicked. And that’s exactly what happens. At some point, sales start to drop and firms and bankers react with shock. Depending on the specifics, the ensuing recession can be a mild dip or The Great Depression: Part Two. Ironically, the firms were right to cut back on production (and the banks correct to stop approving loans) because consumers had the boats/cars/computers they wanted; but just not in the magnitudes that follow. Overreaction works both ways, on the way up and on the way down.

But wait, there’s more! Part 4 follows, where I make an exciting confession: some of this is a fib!

Make sense? I hope so, because now we shift gears. Let me start with a shocking confession: the above is a bit of a fib. That’s not really what drives expansions and recessions, but I thought it would be easier to follow given that it focuses on what consumers do and all of us are consumers. The above certainly happens (I have tables of pretty data to show it), but, generally speaking, it is not what is really at the heart of our ups and downs. That title goes to business investment.


Written by rommeldak

January 9, 2009 at 10:54 am

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