source of recessions
Source Jim Devine
Date 00/01/27/12:43

More seriously, I agree with Doug: the Fed is not the only source of
recessions. The Fed might have done more to fight the one that began in
1929, but it wasn't the cause. (If I remember correctly, Brad's colleague,
Christy Romer, blames the US recession on a fall in consumer spending due
to the popping of the stock-market bubble.) BTW, the amount of inflation
during the 1920s was nil.

Frankly (and when have I not been frank?), I think the cult of St. Alan
(i.e., the view that what happens with the US economy is due to Fed policy)
is irrational. The current boom has little to do with the Fed's policies,
though the Fed could have prevented it, I guess.

On the supply side, the falling of the inflation barrier (the NAIRU) to low
levels of unemployment, or even the disappearance of the NAIRU, was a total
surprise to the Fed (as to everyone else). The Fed was flying blind.
(Mixing metaphors, they don't know _when_ to take away the punch bowl,
since they don't know when the party is going to get wild. They also don't
want to smash the stock market.)

On the demand side, real interest rates have been at historically high
levels since 1990. This should have deterred private investment, but didn't
do so since the government and employers have pushed wages down relative to
labor productivity, boosting the rate of profit, which boosts investment.
Private consumption has risen due to debt accumulation, led by the rich
folks' optimism about the stock market bubble and the poorer folks' need to
make ends meet, keep commitments, and stay up with the Joneses in the face
of generally stagnant real wages. These forces have swamped the
recessionary effects of fiscal austerity (budget surpluses) and the trade
deficit -- so far. All of this "bubble economy" has a heavy component of
irrational optimism. None of this is due to St. Alan. In fact, the
Greenspan cult is partly _based_ on the irrational exuberance (as is the
exaggerated emphasis on the stock market).

If it's forces outside the Fed that have caused the boom, I see no reason
why those same forces couldn't easily cause a recession that the Fed can't
handle. Cutting rates doesn't do much if people are squashed under
exorbitant debts and if corporations are dominated by idle capacity and
rising debt/asset ratios and therefore become pessimistic. (At the ASSA
convention, MIT's Ricardo Caballero told us that with lots of unused
capacity, the "user cost of capital" and thus interest rates become
irrelevant to determining private investment.) Cutting rates may drive the
dollar down, helping the net export situation, but that simply broadcasts
recession to the rest of the world.

Again, I think it's worth reading Wynne Godley (at the Jerome Levy
web-site) or Robert Blecker (at the EPI web-site) or Tom Palley (in the
most recent issue of CHALLENGE).

In a separate missive, Brad writes: >... I have never yet seen an
"overinvestment" cycle: wrong kinds of capital, yes; deficient demand, yes;
inflation control, yes; but not "overinvestment"... <

Over-investment is defined as too much investment from the perspective of
capital as a whole: there's either too much to maintain a sufficiently
high profit rate or too much to allow a stable growth process and thus the
stability of profit income. This "or" corresponds to the two sorts of
over-investment that I have found for the rich countries (in my research):

(I) A kind of over-investment relative to supply occurs when fast
accumulation (associated with high demand for labor-power) pulls up wages,
which squeezes profits. This is associated with raw material prices being
pulled up and excessively high capital/output ratios. It happens in what I
call a "labor scarce economy" such as the US economy in the 1960s and helps
explain the fall of the profit rate in the late 1960s. Of course, the story
is more complicated: expansionary fiscal policy (due to Lyndon Johnson's
war against Vietnam and his fear of domestic opposition) kept the boom
going for a long time, so that profit-rate-depressing imbalances could

Bob Brenner's recent book points to another dimension of this: increasing
international competition among the rich capitalist countries meant that
there was intensified competition over profits which encouraged
international over-investment. This meant that for all of the majors to use
their capital goods at the full-capacity level would have meant even more
of a wage- and raw-material-price-squeeze on profits than actually happened.

(II) The second main kind of overinvestment is relative to consumer demand.
In a "labor abundant economy" such as the US in the 1920s or the
1990s/2000s, wages lag behind productivity so that profits and profit rates
soar and working-class consumption from income fall behind total
production. In order to allow the realization of rising profit rates, the
gap between production and working-class consumption from income can be
filled by (a) rising investment as a percentage of GDP; (b) rising
government deficits; (c) rising trade surpluses or falling deficits; (d)
rising luxury spending by the rich and their neighbors on the income
distribution curve; and/or (e) rising working-class consumption based on
debt accumulation. In the 1920s, (a), (d), and to a smaller extent, (e)
dominated, so that the profit rate could continue to rise; both (c) and (b)
were ruled out. In the 1990s/2000s, the story is very similar, especially
since (c) and (b) are both happening in reverse, depressing the economy.
The big difference, it seems, is that working-class debt accumulation is

Rising investment and debt can allow the realization of a rising rate of
profit for quite awhile (in theory), but they correspond to an accumulation
of imbalances: increasing productive capacity, implying the need for even
more investment to realize a high profit rate, plus rising debt and
debt-service payments. Further, investment spending is notoriously more
flaky (i.e., volatile) than consumption spending, since it is easy to delay
and is based on guesses about future profitability. (If all other firms are
investing, that encourages each to do it; similarly, if everyone stops
investing, the competitive drive to invest fades.) Further, increasing
consumer debts implies that interest payments rise relative to income,
encouraging bankruptcy.

(On the above, see my 1994 article in RESEARCH IN POLITICAL ECONOMY. See or

(III) There's a third kind of over-investment for poorer countries, such as
those of East Asia, pursuing an export-oriented growth path. Competing with
each other for the same rich-country markets, they over-invest in the sense
that if their capacity were fully used, it would mean even lower prices for
them (lower exchange rates). Because of the inelastic demand for their
products (i.e., for the products of their economies all added together),
falling prices or exchange rates don't help them. This is related to the
phenomenon of over-investment by small farmers (petty capitalists), who
regularly invest too much (in the face of inelastic demand) and drive many
of their members into bankruptcy. Falling prices (exchange rates) simply
make debt service more expensive. Since the investment boom usually
corresponds to debt accumulation, this is crucial.

>... -- after all, enough monetary expansion can push interest rates low
enough to make *any* investment that is at all productive profitable...<

Caballero's research points to the real phenomenon of the vertical IS curve
due to excessively idle capacity (along with excessive corporate debt and
pessimistic expectations). This is what I call the Depression IS curve:
falling interest rates do not induce much if any investment under these
conditions, so that there's little increase in GDP. This situation can be
reinforced by excessive consumer debt, consumer pessimism, and overbuilding
in the housing market. (This is a situation that Leijonhuvfud would call
"outside the corridor.") Real interest rates cannot fall below zero unless
expected inflation rises significantly (as my old roomie points out). So,
absent severe inflation, even a steep (i.e., non-vertical) IS curve may not
intersect the LM at full employment. (Note that even before zero, there's a
floor on interest rates because of the liquidity value of money as an
asset.) This implies that monetary policy suffers from ED.

In this kind of situation, expansionary _fiscal_ policy is needed. But of
course President Coolidge -- oops, I mean Clinton -- wants to commit the US
to "paying down" the government debt by 2013. Most of the GOPsters will go
along, of course, though they might push for some gifts to the rich (just
as the Demsters will push for mild gifts for the middle class). So it will
take a big crisis to shake the government to change course and expand the
economy. Maybe a war...

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