Post-Keynesian Observations

Understanding the Macroeconomy


with 8 comments

[NOTE: Be sure you have read part 7 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. Part 8 was a bit of a digression so you don’t have to read that one first.]

I was thinking that I would need to lay in more background at this stage, but I guess we’ve really covered everything necessary to give basic explanation of the business cycle and crisis. So, this post will try to tie together the various strands from parts 1 through 7. Also, I’m going to try to do my first graphics in WordPress!

Check out the figure at the bottom (assuming it shows up!). It breaks the business cycle into four segments: early recession, late recession, early expansion, and late expansion. In addition, it focuses on a limited number of factors: animal spirits, demand for investment goods (firms adding to productive capacity) and consumer durables, debt levels (measured as the ratio of total debt to income), actual profits, and expected profits. I decided to make the key factor in each half cycle the contrast between what firms expected to make in profit and what they did make. All of this is a major simplification but I think it will give you a feel for what generally happens (and what just happened!).

Let’s start with the early recession in the top left. The shock of collapse is fresh and thus animal spirits are low, too low to effectively offset the uncertainty that exists. Low animal spirits lead firms to expect only low profits, and firms, consumer, and banks are willing, in this depressed environment, to take on only a little debt. Meanwhile, the markets for physical investment (factories, etc.) and consumer durables remain saturated from the expansion. Therefore, not only do people expect low profits, they get low profits. The pessimistic expectations are confirmed and there is little change in animal spirits.

As the recession continues, the natural tendency of animal spirits to be propped up by spontaneous optimism starts to kick in. Still, however, they are low and thus little is expected of profit and debt levels remain low. Productive capacity and consumer durables are starting to wear out (plus new technologies and tastes come along), however, and thus there is a mild recovery in their sales–profits are moderate but increasing. This is a pleasant surprise and animal spirits move upward, but only cautiously.

Eventually, the recovering sales and rising animal spirits lead to an expansion. Expectations of profit are moderate but rising, and firms, consumers, and banks undertake increasing levels of debt to finance their activities. Because it’s been a long, barren recession, however, lots of factories and consumer durables need to be replaced and thus profits turn out to be high. This is a pleasant surprise and leads to a rapid increase in animal spirits.

However, the expansion cannot continue. Demand in the markets for physical investment and consumer durables can, given our technology and resources, be met in a short amount of time (several years). Once you have rewired your company for high-speed internet, you don’t want to do it again next week. Once you have built that new store in Dayton, you may be done expanding your presence in Ohio (or the Midwest or the USA or the world). Once you have that new XBox360, you don’t need another one for a while (wait, given their failure rate you might!). Profits inevitably decline. On top of that, you’ve gone into debt to finance all this and so you are right at a point when you want to stop spending and start paying back. Ironically, however, animal spirits and profit expectations are at their highest point. We are already spontaneously optimistic, and the rise in our enthusiasm was fueled by the pleasant surprises of higher-than-expected profits during the Early Expansion. Because expectations and reality are moving in opposite directions, we are now ripe for shock, disappointment, and collapse. And the cycle is complete.

Let me stop for a moment and reiterate. By late expansion, our animal spirits and expectations of profit are at their high point. This means stock prices are sky high, too, and stock holders’ tolerance for poor quarterly reports very low since they are used to hearing about successes. Banks are every bit as excited as everyone else and they have been approving loan after loan, accommodating the rising debt levels. In fact, banks are seeking out the high-risk customers now and, in the heady days of peak expansion, aren’t looking all that closely at credit-worthiness. Consumers are offered lots of good financing deals and those who did not partake in the buying before will now decide, “What the hell–if the Smith’s can afford a new plasma TV, so can we!”

At some point, someone somewhere says, “Whoah! Sales are way off of what we expected!” If the gap between expectations and reality is big enough, this can evolve into a full-blown crisis. The level of debt everyone is carrying makes us even more susceptible.

There are several other complicating factors (including some historical developments) that I’m dying to put in here at this stage, but let me stop. This gives a basic sense of what causes the business cycle and crisis. Not every recession evolves into crisis and the expansions can be quite long. But, the way our system is currently designed, it lends itself to periodic crisis. What just occurred in our economy is hardly a surprise. I think I have now given enough background to go over some historical developments that will allow you to understand where we are today.

I don’t think that will be part 10, however, as I think I need to stop and say a word about policy. I said above that the way our system is currently designed, it lends itself to periodic crisis–does it have to be designed this way? No. Stay tuned!


Written by rommeldak

January 20, 2009 at 10:42 pm

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  1. So, given all that, and your proposal that our system is designed to cycle in the way that it does and has for the last what, 150 years? 200 years?, how do you see technology, with what seems to be its ever increasing rate of change and designed obsolescence, and a continuously growing demand for forced investment (depleting the principle) just to keep up with basic technological needs, effect/affect the resources required to keep the cycle ongoing, rather than either:

    a. eventually bottoming out altogether leading to total global financial collapse, or

    b. a science-fiction like massively wide gulf of separation beween the 90% of the planetary population having virtually nothing, ruled totally by the 5% who have virtually everything, and a wee sidelined 5% “middle class” left to meekly record it all for history?

    And how can we prepare/recover from such a scenario?

    Or is such a scenario too far fetched in contemporary times?

    If I’m not clear, or if I’ve muddied the waters with my acknowledged naivety, please let me know and I’ll try to clarify my rather thin thoughts.


    January 22, 2009 at 9:33 am

  2. Whew, finally getting to your comment, Sic–sorry!

    No, that’s not muddled. I think you are getting right to Keynes’ horrible fear: that the system will get worse and worse as technology gets better (making the saturation of demand for investment goods and consumer durables faster), so much so that we either collapse or end up with some sort of totalitarian state. I think there are a couple of things to say here:

    1. It’s safe to say that in 500 years (at least), we won’t recognize the economic system any more. It would be awfully arrogant of us to think that history has ended and these are the social systems we’ll have from here on out. I’m quite sure the Romans thought the same thing, as did the Greeks, the Han dynasty, etc.

    2. Actually, Keynes was pretty upbeat about the whole thing. While he was worried, he also thought we’d solve it. Here is his classic esssay, The Economic Possibilities for our Grandchildren:”

    We are those grandchildren, of course!

    3. Basically, the economic problem has been solved. We can create plenty of goods and services for everyone on the planet. Our remaining issues are philosophical. We have to decide how we want to live and what is right and just and fair. To explain that would take a whole new post and I’d like do to that.

    Bottom line: I don’t disagree that your a and b could happen. I hope they don’t, because they certainly don’t have to. If they come to pass, it’s because we lacked the courage and introspection to see the real problems and face them.


    January 27, 2009 at 10:56 am

  3. Keynes’ evangelical zeal in this article cited above for a New Jerusalem (a reborn post-industrial society in the UK) had yet to run into the small matter of Britain’s bankruptcy only two years into WWII.

    You could say Keynes’ optimism for us, the UK’s grandchildren, was a last hurrah of the late Victorians. A belief that rumbled into the post-war period that Britain’s destiny was always at the top table; we were in collective denial that our global dominance, long predicted mind, was finally and catastrophically over.

    Despite this masterful ‘self delusion’, for some this New Jerusalem came to fruition with the quantum shifts in the socio-economic-political landscape in the UK. Despite crippling conditions by the US govt for loans to the UK this vision was held up with ‘social democracy’ poking its head up between the prevailing extremes.

    Suggests that a political programme can prevail despite the numbers looking awful! But you first have to have a programme and the moral imperative for change.


    May 31, 2009 at 4:00 am

    • Moral imperative, indeed. That’s the problem. Physically, we can solve most of our real economic issues, but the ultimate problems are philosophical. Keynes wrote in 1936 that we are all the slaves of some defunct economist and that the slow march of ideas is really stronger than that of vested interest. I discounted it at the time, but have come to believe that he was dead on. Ideas are what hold us back much more than existing technology.


      May 31, 2009 at 9:39 am

      • Indeed it is; and the marxists amongst might rightly complain there have been no platforms or forums for ideas to breathe anywhere as we have stifled meaningful debate. The seeds of our demise are sown early, from school onwards. We have no patience for children to be children and use their imagination as we need them to be adults quickly to feed the growth cycles.

        And what is the idea we’ve truly been living in – do we know it and understand it; structured, heirarchical Christendom where the moral imperative is such a heady mix of rationalism and self-righteousness? Did we miss our grand destination by, say, by 5 degrees to starboard? We were so on target for much of the journey but we’ve arrived and we’re in the wrong place.

        Drucker might add to this that, “Technology is not nature, but humanity” and any linear separation is therefore artificial; viewing any ‘cycle’ in linear terms is redundant, consumed by the creeping complexity that is beyond ‘human control’. Are we then in a decaying paradigm where complexity has consumed ‘cycles’? Hamel and his zealots have been appealing for new forms of value creation but we’re wedded to three month growth cycles and no-one is jumping off that bandwagon.


        June 1, 2009 at 12:02 am

      • I don’t know Drucker or Hamel, but I think those concepts are dead on. Indeed, technology is human, period, and I have always been very skeptical of studies that claim to have discovered regular cycles through human history.

        Regarding have a place to get alternate ideas on the table, I was the director of this group for six years: Our goal was to get discussion/debate going on between various schools of thought in economics. As it stands, our discipline is absolutely dominated by the neoclassical mainstream, which is wedded to the rationality assumption (among other things) that helped bring us our current financial crisis. Another group that just srprang up a few days ago is Toxic Textbooks: They are pushing for greater variety in the econ texts used to indoctrinate our students.

        We are hopeful, but then so were those who undertook these same efforts fifty years ago!


        June 1, 2009 at 2:48 am

      • As a management academic rather than economist I still hear this appeal and would hope your students might find Polanyi offering a form of words that capture our journey into embedded rationalism, as follows (from Meaning by Polanyi and Prosch):

        “After the First World War our historians abandoned the vision of the Enlightenment that had evoked the dream of unlimited moral progress.

        Positivism [rationalism] had set out to eliminate all metaphysical [religious et al] claims of knowledge.

        Behaviourism had started on the course that was to lead to cybernetics, which claims to represent all human thought as the working of a machine.

        Sigmund Freud’s revolution had started too, reducing man’s moral principles to mere rationalisation’s of desires.

        Sociology had developed a programme for explaining human affairs without making distinctions between good and evil.

        Our true convictions were being left without theoretical foundation.

        One might indeed say that we too renounced the ideals of the nineteenth century. Alan Bullock wrote of Hitler that he was terrifyingly literal, and this was true also for Lenin. Our academic wisdom has lain, on the contrary, in never meaning what we said; our version of the disasters of Europe was a harmless whisper of their teachings.

        History will not celebrate this performance, but it will still recognise that it kept us faithful at heart to the ideals of the nineteenth century.

        In general, therefore, our morally neutral account of all human affairs has caused our youth, and our educated people in general, to regard all moral professions as mere deceptions – or at best as self-deceptions.

        For once we induce ourselves to regard all established rules of moral motives as mere conventions, we must come to suspect our own moral motives, and thus our best impulses are silenced and driven underground.

        Such self-suspicion does torment our age, and particularly our youth, seducing them into destructive forms of moral expression, since these alone seem proof against self-doubt.

        In other words we… have been busily engaged in laying the groundwork for nihilism.”

        Michael Polanyi Harry Prosch, Meaning (1975 as well!)


        June 5, 2009 at 10:43 pm

  4. That’s very interesting stuff. It’s consistent with the argument of my school of thought in economics that there is no such thing as a view except from a view point. The mainstream says that they aren’t giving opinions in their analysis, just “facts.” We argue that there is no such thing, that even the choice of what to study in the first place is a moral one. We had to read Polanyi’s brother, Karl, by the way, in graduate school.


    June 6, 2009 at 9:08 pm

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