Risk Latte - Anatomy of a Recession and the Depression Economics

Anatomy of a Recession and the Depression Economics

Rahul Bhattacharya
October 15, 2008

In 1999 Paul Krugman wrote an excellent book called "The Return of Depression Economics" to analyze a world, especially Japan, the rest of Asia and other emerging markets that was lying prostrate after the Asian financial crisis of 1997. The book was, perhaps, ten years too early.

Why do recessions happen? The short and the simple answer is that recessions happen when people start to horde cash and stop spending.

There would be new cars and SUVs displayed in the showrooms and people would pass by the shop windows admiring these vehicles but no one would be buying them. You'd have perfectly operational factories, with all operating and production resources in place, sitting idle and not be producing anything, with machines switched off; for the goods that these factories will produce cannot be sold, as no one would want to buy those goods. You'll have your baker, your corner grocery store, your locksmith, your salon all open for business but there would be no business because you have decided not to buy any more bread, skip a meal to save on your monthly grocery bill and not go for that weekly hair styling sessions. And why are you doing all this? Why are you cutting back on these items? You are doing this because you are suddenly fearful that you'll lose your job, if you haven't already lost it; you're fearful that once you lose your job it may be a long, long time to get another one and during that period you. Therefore, you want to horde cash for a truly rainy day.

You are not alone in doing this. Everyone else around you is doing the same. And the irony of it all is that because all members of your society - economy - are spending less and less everyday to save more cash for tomorrow all of you are witnessing a fall in your personal income. When a large number of people stop buying bread from the baker the baker will not be able to keep up with his costs because he won't be able to make enough money. So he starts to lay off employees, who then stop spending on their grocery bills and eating out and eventually the corner restaurant and grocery store start to lose money and lay off employees and thus a viscous cycle is unleashed.

A lot of people become employed and others fear for an imminent loss of their jobs or loss of purchasing power (lower salaries and bonuses, dividends, etc.) and contemplate a long road of economic hardships ahead. All the "unnecessary" and fanciful goods and services in our lives are done away with; no second car, sell the existing one at whatever price and start taking the public transport, save on gasoline; no vacations, no Sunday brunches and no more Christmas shopping.

And soon this savings frenzy will result in loss of income for all and eventually people will not have money to spend, for they would not be earning any money.

And it all happens because our collective perception of reality has changed, almost overnight.

It's a behavioural phenomenon, something that cannot be completely understood using mathematical equations and models that economists use. True, economists try to understand recessions using mathematical models, IS-LM graphs and differential equations. But they all realize that at the end of the day it is a socio-behavioural problem. And that is where the frustration comes in. That's where, understanding the phenomenon of economic recession becomes such a challenging and, dare we say, a fascinating task.

Why do whole societies suddenly stop spending and start hording cash when only yesterday they were spending money and consuming all kinds of goods and services like there was no tomorrow.

And the funny part is that even if Uncle Sam comes along and hands you a $100 bill saying, "hey Joe, don't worry, here's a hundred dollars, now go and spend it on that meal that you were planning to skip at the corner steak house"   you may simply pocket that $100 and save it for another rainy and still skip the meal. You are not sure if Uncle Sam will back again on another rainy day.

It is one of the supreme ironies of our economic lives that just when we realize that savings is such a virtue for each one of us individually, it becomes a vice for the society as a whole. Depression economics begins when savings become "excessive savings".

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