The Evolution of a Recession

Starting from a situation where things are rosy, an economy continues to experience growth from the typically ongoing technological changes that raise productivity levels. The result is higher incomes and increased spending, and this reinforces incentives for businesses to produce more output, innovate, and technological change occurs... This is the virtuous cycle that describes the desired normal for an economy.

But that is until it experiences a shock in economic activity.

Shocks, as economists typically call them, refer to some typically unanticipated event (one time or ongoing) that is sufficiently large enough in its impact on the aggregate level of economic activity. In market economies these shocks typically affect either the demand or supply side of economic activity, and examples include sharp and often persistent stock market crashes, housing market crisis, financial market crisis, a political upheaval, sharp movements in oil prices, persistent droughts, and well... plagues or pandemics like the current coronavirus or COVID-19.

The examples cited above are not necessarily exhaustive. For one, I have focused on the typical negative shocks, not the positive ones, the latter which are desirable as they indicate for the economy faster rates of economic activity and hence growth of incomes. Secondly, I have only focused on those that might be unambiguously obvious, perhaps in retrospect, and not all possible shocks that economists typically identify such as those that are believed to be the result of monetary policy actions.

Negative shocks do not necessarily mean recessions are inevitable.

They signal to the economy that we have been rocked off our normal equilibrium and they set in motion the need for adjustments in incentives to cope with this outcome.

The traditional economic understanding of how an economy responds is that we would see an orderly adjustment take place, given an implicit assumption that behavior in the public is rational, in the sense of being fully informed and being able to make decisions based off that information in a systematic manner that further one's best interest.

If there is a negative shock that affects spending or the demand side of the market, we expect that the fall in spending will cause prices economy-wide to fall as businesses with profits on their minds realize that they need to cut their losses on the rapid buildup of unwanted inventory by reducing prices on their products so as to sell them and at least cover some of their incurred production costs.

The lower prices will induce people to return back to spending and this moves economic activity back to its previous levels, though the economy operates where prices are lower on average.

Similarly if the negative shock affects the supply side of the market, then because of the contraction in production the ensuing scarcity would see prices go up to ration available production among competing needs. The higher prices would encourage more business production and we should return back to previous levels but at a higher level of average prices.

Given this orderly adjustment by markets, how then do recessions happen?

There are various schools of thought in economics on this and to flesh out the entire arguments will be well beyond the scope of this article so I will provide what hopefully will be a short, compelling, but probably unsatisfying answer for the pedantic, but it should suffice if you want the general idea.

First, behavioral adjustments to shocks are not necessarily orderly because in the real world people and businesses take many things into consideration: how they feel about the situation, whether to wait a little longer before taking action, whether they do not need to take action given the nature of what they produce or sell, what they think the government or other policymakers might or might not do etc. A general catchphrase here that is often thrown around in economics is price stickiness.

Price stickiness captures the idea that the normal price adjustments, especially in some key markets, such as labor markets, do not happen quickly as the traditional perspective says they would. As a result, instead of orderly adjustment, things spiral from bad to worse - with the negative shock to demand, spending continues to fall. With the negative shock to supply, the problem moves from a fall in production to a fall in earned incomes, so it morphs into a demand side problem as spending then falls as well.

A recession then ensues because there is no (or if at all any, slow) adjustment back to the previous level of economic activity, so economic activity contracts and continues to for a significant period of time and spreads throughout the economy. Widespread loss of jobs results and various measures of economic activity capture this downward trend.

The notion of price stickiness is a mainstream economic idea but it is not entirely subscribed to by some economists still within mainstream economics who think a more compelling argument about what causes recessions could be explained by focusing almost entirely on negative supply shocks without price stickiness.

Though this perspective does continue in the long proud tradition of lending itself to sophisticated economic analysis it has been thought to only be largely relevant in explaining the stagflation recessions of the late 1970s and early 1980s, when economies faced oil shocks due to the OPECs decision to cut oil production which sent oil and energy prices skyrocketing, economies into recessions with corresponding high levels of inflation.

The Global Pandemic that is COVID-19

Are we looking at a possible recession from this ongoing pandemic? Yes. But how is this unfolding?

In its initial phase the coronavirus pandemic is a supply side shock - it affects the ability production facilities as workers find themselves either infected and unable to work, or quarantined or isolated in a bid to limit the spread, so that again they cannot work, so all forms of production that cannot be performed remotely or at the same levels using alternatives that limit the need for physical workers being present on the job site will see a reduction in output.

China, a major source of global production by virtue of their very large and relatively cheap labor force was the first to be hit by the crisis and this led to a huge shutdown in production as the government took steps, draconian in some regards to curtail the spread of the virus (with some degree of success as the data currently suggests).

The pandemic, by definition, has spread to other countries and this has been followed by measures taken to limit the spread that includes in some case such as in Italy and South Korea, similar draconian measures, and in the US to a widespread reduction in supply of economic activities - entertainment, education, public services, and private sector production.

In the view of economists who see recessions as driven by supply side shocks without price stickiness, this should alone bring about a recession given the scale of economic activity that has been reduced in terms of production, but this view suggests we should also see average prices rise as the economy rations the now reduced output.

The price stickiness advocates might concede that indeed we have a supply side shock, but they would also argue that it ultimately affects demand, because the lack of economic activity on the production side ultimately would mean a loss of incomes to be earned, and so spending will necessarily fall. This should keep prices from rising (or from rising too quickly), while the economy does fall into a more severe recession, given the slow adjustment of prices, that is, the presence of sticky prices in some markets.

Mitigating an impending Recession

While we are not officially or formally in a recession, as the official declaration tends to come several months after the fact from the National Bureau of Economic Research (NBER), since it has to meet at least the prerequisite of being long in duration, the current crisis has all the hallmarks of a recession here in the US and likely all around the world.

Countries have already begun to take the standard and in some cases not so standard policy measures to mitigate economic contraction. Here in the US, the Fed acted a little over a week ago in emergency fashion to cut interest rates by 0.5%. It has since followed up on that with several rounds of repo activities aimed at increasing liquidity within the financial market, all actions intended to both encourage investor optimism in markets, and to provide for cheaper overall lending to boost credit based spending.

The US Congress has passed an $8.3 billion financial package aimed squarely at fighting the coronavirus, and President Trump has since then floated the idea of payroll tax cuts and additional relief for hourly wage workers. Congress has also suggested that talks are currently underway for a bigger fiscal stimulus given the concern that the fall in spending levels will lead to job cuts and loss of incomes for households, many of whom now face the prospects of not having to work due to closures, isolation and quarantine actions and recommendations being put in place across various workplaces.

With careful targeting, these policy measures could shift both supply and demand levels in the opposite direction from where they are currently headed given the impact of the coronavirus: the monetary policy being put in place by the Fed should help to raise the level of spending, as would any income support and direct increases in the government spending aspects of the fiscal packages put in place.

The problem though remains with the supply side. Ideally policies that reduce costs of production for businesses would have the effect of increasing production so any aspects of the fiscal package that does this should stimulate production, as would the fall in oil prices, which we are currently experiencing. However, this does not address the fact that labor may still not be available if nothing has changed with respect to the resolution of the crisis - a vaccine to cure the disease, or reduce its spread, or the mortality rate associated with the disease.

If output does not increase and spending continues to be boosted, while we may end up avoiding a recession or having only a mild one, we may have to deal with much higher levels of overall prices - inflation in the economy. This I have explained in a previous blog post might be one of the reasons why the stock market has failed to react in a sustained positive way to all the various policy measures being enacted by governments across the world. The supply side problem has not yet been addressed.

This is why as I have also stated in a different blog post that targeting of any fiscal stimulus needs to be done in a way that pushes us at the fastest pace possible toward resolution of the problem - finding a cure for the virus, or something that frees workers to return to productive activity in all industries.

New Drugs: Speed versus Caution

The process by which new drugs get introduced into the economy faces the philosophical tradeoff of having a safe drug that does indeed save lives because sufficient testing has been carried out against having one that is not safe because it was released without sufficient testing and turns out to have unintended consequences that could be disastrous not only for those using it, but perhaps to others as well.

The process tends to err on the side of spending sufficient time to test the drugs first, which is why the very optimistic estimates are on the order of 9-18 months for finding a viable cure and providing it in sufficient quantities to make available to infected people. Would throwing more money at this shorten this time frame? Would throwing more money at this allow us to take a risk in policy change and err on the other side, but now expecting lower odds that we would have that outcome? Possibly.

Money or to put it in more economic terms, incentives, when sufficiently high, move resources to be allocated in the direction the incentives dictate, and unfortunately it will get us into ethical debates. Would infected individuals be more willing to have experimental drugs used on them if handsomely compensated? Would healthy young populations be willing to? Should anyone even be asked to consider this choice?

Admittedly, with a lot of money on the line, unscrupulous and unlawful activities might be engaged in, and we have a history of such things having been done in the past in a bid to find cures, and the victims tend to be the poor, the marginalized, "those who can be made to vanish without anyone looking for them". It is usually for similar reasons that the sale of organs tends to be prohibited to prevent a slippery slope into the cheapening of human life (and serial killings for profit).

So here is where governments and communities have to be able to draw the line and stand united. Incentives are needed, but rules have to be put in place, so there should be plans by the government to spend additional resources to regulate so that business practices in the area of experimentation with new drugs is fully transparent and meeting socially acceptable moral rules.

Economists, staying through to our profession, would remind us that when we think about the ethics of compensating people for volunteering as guinea pigs we must remember that in the normal vocations of life and work we do the same thing - people are asked to take risks - those who currently work as healthcare providers taking care of the infected, those who work performing the disinfecting of public places, first responders, who have to react to people in need with actions that endanger their lives, high rise window cleaners, and builders who risk their lives should things go wrong with the scaffolding, and we could go on - for compensation.

So in the same spirit I will reiterate. Focus spending on getting a cure and this will help calm markets in the short term, and in the medium term get supply back to previous levels and mitigate what is very likely to be an economic recession, here in the US and globally.