Tuesday, August 16, 2016

As I've Said Before

Sometimes it’s worth saying things again. The economy changes, but economic principles don’t. So some of what I’ve written can be said again and apply as well today.

I’ve posted a couple of collections of economic “best of” posts:

·         In June of 2013, Best of the Spherical Model, Part II 
·         In March of 2015, More of the Best, Part III 
Among these are some that I think are repeating in full. These two go together: “Parabolas,” from November 2011, and “The Trampoline Effect,” from March 2012.  When we’re in the longest malaise (being called a tepid recovery) since the Great Depression, maybe it’s worth reviewing these.


Natural paraabolic shape
of a recession and recovery
With recessions, the rule is: what goes down must come back up. The natural shape of a recession is a parabola. There’s a sharp drop to as low as it’s going to go, and then the direction changes upward during recovery. If it is allowed to follow the natural course of events, the recovery will essentially mirror the drop—and then keep going up. 
This is a concept my sons, Economic Sphere and Political Sphere, have been sharing with me from time to time. I don’t have the economic math skills to reproduce all the math logic for you, unfortunately. But I think the basic concept will do. Recessions happen because the market needs to correct, from a bubble or maybe a natural disaster--something that interferes with the natural long-term aggregate growth of the free market. But once there’s a drop, then a naturally growing market returns.  

Political Sphere shared an article from Forbes about the concept that recessions follow a natural course—unless interfered with. The article makes that point that the excuse “this time is different” is never true. 
L-shaped recession, natural
recovery is prevented

Real trouble happens when there is interference, usually intended to “help.” According to Wikipedia, one of the shapes a recession can take is the L shape. In this one, the sharp drop happens just as you would expect. But then, instead of bouncing on the bottom and coming back up, the level just sort of dribbles along horizontally near the bottom. Other names for this are “depression,” “lost decade,” and “malaise.” These are all terms beginning to be applied to our current L-shaped recession. They are terms that applied to FDR’s Great Depression as well. 

What is it that causes this recession to be different, to languish at the bottom instead of bouncing back? Government interference. How do we know? 

This is maybe more than you wanted, but here’s a basic formula: 

Y = C + I + G + NX 

Y is GDP (production) in actual dollars.
C is consumption, which is a function of Y-T (taxes).
I is investment, or infusion of new capital (not spending on used materials, or stock exchanges).
G is government spending.
NX is net exports. 

Government can affect Y by increasing spending or raising or lowering taxes. More taxes means less money for consumers to spend, and less taxes means more money for consumers to spend. Indirectly investment will be affected if Y decreases, when there is less profit to be made. But mainly the other way government can change Y is by increasing government spending.  

I had to ask Economic Sphere why the formula includes “+G” instead of “-G.” In theory, G is just another product consumers (we the people) spend money on. To some degree it’s necessary. So the amount spent on G is just another part of the measure of GDP. However, when spending on government is too high—includes debt—it temporarily appears that the G portion of the economy shows actual growth in GDP. But that is an illusion.

natural ups and downs of
business cycle show a sine wave
It appears, in the short run, that government spending (or stimulus) increases Y. But Y’s rate of growth is, in a natural free market, fairly constant. There is fluctuation, an ongoing sine wave, or little rises and dips, but you can draw a line through that at approximately the natural rate of growth (maybe somewhere near 4%). Government spending can’t change that. It doesn’t affect aggregate supply; it only affects aggregate demand. So it may appear for a time that it has affected growth, but there will be a natural pull back to the equilibrium point where aggregate supply and demand intersect. There will be a correction. So the more government does to try to make the market go up, the greater will be the eventual correction back to the natural rate of growth. 

The longer and greater the government over-expenditures, the more drastic will be the inevitable correction. 

So what happens if government sees that inevitable drop and tries to prevent it—with more government spending? It causes an even greater drop. If the measures are taken after the drop, presumably in an effort to stop more drop or cause a rise, it interferes with the natural recovery. That is what we’re seeing now. 

Greater government spending at a time when great government spending already caused the dip is like hitting the economy over the head and beating it down. Every new interference, every new beat down, leaves the economy languishing down at the bottom, unable to rise because of the repeated drop-causing interferences. When they say, “The economy was in much worse shape than we thought; imagine how bad a shape we’d be in if we had done nothing,” you can know for certain that things are worse because of what they did in their ignorant attempts to control a natural force.  

If government wants to have a positive effect on GNP, it needs to cut spending. Since it can’t (won’t) cut to zero, the next best thing would be to cut to the bare bones of the enumerated powers of the Constitution. At the same time, lowering rather than raising taxes will help. Both lowered government spending and lowered taxes leave more money available for growth.

The Trampoline Effect
The other night I was reading something about the recovering economy—a recovery so tepid we can’t perceive it; instead we must take government’s word for it. Never comforting. And the reading led me to talk with my son Political Sphere about the concept that, the deeper the recession, the stronger the following recovery. I wrote about this principle with more detail in “Parabolas” on November 21st.
So, we were discussing this concept, and Political Sphere unveiled what he calls the Trampoline Effect. On a trampoline, the harder you come down (from a higher or heavier fall), the higher and more powerful the bounce back up. But if a big brother (yes, he worded it that way, with plenty of extra meanings) steps in to “help,” it doesn’t help. It usually disturbs the bounce, taking the energy out of it, and you end up with buckled knees and a few small bounces fading into flatness.
photo from trampoline.com

Picture the difference between a parabola (the natural down and back up bounce) and what is euphemistically referred to as an L-shaped recovery, but is really just the dribble that happens from interference in the bounce.
Big Brother “helping” is the government stepping in, taking actions that interfere with the energy of the natural growing economy.

So, every time you hear someone say, “We had to do something,” or “Think how bad it would be if we hadn’t taken action,” translate that in your mind to the Trampoline Effect. Does the jumper need you to step in and “help” in order to bounce back up? No, that is going to happen unless you interfere.

A recovery, by definition, is coming back up to at least the starting point. If that hasn’t happened, we’re either still going down, or we’re stuck down flat because of the interference. What we need is for Big Brother to get out of the way so we can make a few small tentative bounces and put our energy into building up a good parabolic rise. But every time he steps in, he zaps the energy out of your bounce and leaves you flagging.

1 comment:

  1. Y = C + I + G + NX is a static model and only deals with one time period. What's more important over time is the change in Y (dY). If we change the function for the change then dY is a function of I(s,r(s)) where s is savings and r is the real interest rate. Government expenditures artificially raise the real interest rate by taking from savings either through government debt (treasury bonds), or decreasing incomes through taxes.
    Someone may notice that I assume that government spending is not also investment, and you're right, but other than infrastructure spending you'll have a hard time showing any sort of GDP growth. Now for the infrastructure spending we look to stimulus data from previous government responses to recessions and come up with an estimated return of about -33%, which is pretty abysmal.
    All of this can be summed up with one simple sentence. Less government spending means faster economic growth. Or, less government, more jobs/wealth/goods produced.
    P.S. Another takeaway is that savings drives investment, not consumption.