The business cycle refers to economy-wide changes in
production over a number of months (or years). During the upswing
of the cycle, total output increases at a relatively fast pace, worker
productivity increases, and unemployment generally declines.
During a downswing, production declines as factory capacity and
labor go unused. Companies shutter plants and lay off workers.
A recession occurs when a deterioration in the economy’s output
lasts for two consecutive three-month periods.
During the late 19th and early 20th centuries, there was
widespread agreement among economists as to the causes of the
business cycle. Recessions and unemployment were the result of
changes in the structure of production (i.e., the type, location, and
labor composition of output)—exactly as Edward had posited.
This is known as the Classical theory of the business cycle. It is
the most lucid explanation for why recessions occur, which makes
you wonder why it hasn’t been taught in university classrooms for
the past seven decades. I myself hadn’t encountered it in any form
until I eavesdropped on Edward’s lecture.
Prior to Adam Smith’s writings, economic slowdowns were
generally attributed to a scarcity of money and/or a general
overproduction of goods. Smith had exploded the first myth in
The Wealth of Nations. (Remember, producing more money only
results in higher prices, not more production.) Jean-Baptiste Say
developed his “Law” as a means of repudiating the “overproduction”
fallacy. There could never be excessive production of all goods, Say
claimed, only of particular goods.
Although Say didn’t write extensively about the business
cycle, Say’s Law provided the foundation by which later economists
understood it. As economies developed, production became
increasingly specialized. Greater division of labor (and capital)
enabled quantum leaps in productivity. Consequently, standards of
living dramatically improved. People were able to consume more
goods simply because they were producing more of them.
However,the division of labor and capital that Adam Smith heralded
as the great driver of economic productivity had an unfortunate
downside. In a developed economy, people do not consume most of
their own production but rely extensively on trade. The welfare of
individual businesses and workers depends heavily on their ability
to find willing buyers for the goods which they produce. Therefore,
each economic actor must forecast what sort of goods that others
desire for months (or even years) before he actually produces it.
For example, a woman who attends medical school and studies oncology
is making a prediction that chemotherapy will be needed after she
finishes her residency. Effectively, she is wagering that cancer
will not be cured until many years after she begins to practice
medicine. Of course, if a bona fide cure for cancer is discovered,
she will find that the demand for her services will quickly evaporate.
Now imagine how the doctor’s spending habits will change
when the market no longer has a need for her specialty. Because
she is no longer producing a BEST WAFFLE MAKER valuable good, she will lose her ability
to purchase the goods and services of others. The medical service
that she had been supplying may have constituted a demand for
a luxury automobile. If the doctor can no longer sell her services,
the car dealer will soon find his own sales declining. As the car
dealer sells fewer automobiles, the demand for steel and rubber will
decline in turn.
The principle here is simple, yet profound: if one person
fails to produce a desired good, she loses the capacity to purchase
someone else’s production. That is, one person’s supply constitutes
another person’s demand. If one set of producers cannot buy, then
another set cannot sell. So a disruption of supply in one market
affects the supply in another market, and so on. Economically
speaking, John Donne was absolutely right in stating that “no man
is an island.”
As the doctor’s situation illustrates, production miscalculations
are quickly transmitted from one individual or business to another.
Because one person’s production is another’s consumption, a
reduction of output in one industry reverberates throughout other
sectors of the economy in a chain reaction. That is, declining supply
in one sector reduces the demand for products in other sectors.
Production miscalculations can occur as the result of a
sudden “disruptive” technological breakthrough, as in the case of
the hypothetical cancer cure. But in most cases, the errors usually
occur as a result of the pride/credit cycle. Rising asset prices cause
too much capital and labor to be allocated to a “hot” industry (such
as the housing market in recent years). The greater the misallocation
of capital and the more leverage employed, the greater the adverse
repercussions in the broad economy.
While relative overproduction of undesirable (or unprofitable)
goods may temporarily occur, a general overproduction of goods
is not possible. Economic downturns do not occur because an
economy has produced too much of everything. Resources become
idle only because they have been producing certain goods that are
no longer in demand.
A general “demand failure” is never the cause of recession,
because supply is always the basis for demand. The problem of
recession is that supply exceeds demand in particular segments
of the economy. Companies that fail to supply the correct type
of goods, at a market-clearing prices, will be left with unsold
inventories or unused labor. Consequently, the “unused” laborers
soon receive layoff notices.
It’s easy to deride the market as a callous, faceless institution
that cares only about profit and nothing for an individual’s job
security. But that attitude betrays a misunderstanding about what
the market really is. “The market” is really just another name for
“the people,” and it is the most purely democratic institution
on earth. You can think of each dollar as a vote. The number of
votes you receive is a function of how much worthwhile stuff you
produce for other voters. If you are making a product that is in
high demand, but is in short supply, you will garner a lot of votes
in the form of dollars.
By equating “the market” with “the people,” recessions can be
understood as a referendum on the economy. The question being
decided is how society will allocate its resources. The electorate
casts its votes for businesses that generate value in the form of highquality
products and/or competitive prices. Those companies that
produce undesirable products or whose sales cannot cover their
production costs are voted out of office.
Some 19th-century economists believed that recessions
and unemployment resulted from overproduction of all goods.
Recessions, they claimed, resulted from being too productive! Of
course, this notion is a total canard. Think about it: if recessions
were caused by making too much of everything, then society would
be in a constant state of depression and our standards of living
would not have improved exponentially over the past two centuries.
Say’s Treatise provides the key to surmounting recession and
unemployment: “when a nation has too large a quantity of one
particular type of product, the means of disposing of them is to
create goods of another variety.” The appropriate response to recession
isn’t to quit producing; it is simply to begin producing different items.
Economic recovery arrives as businesses rationalize their costs, reprice
existing products, and offer new products that are in demand.
Recessions, while uncomfortable for those adversely
affected, are a necessary adjustment process. Capital and labor
are redeployed from industries where there is too little demand
into areas where there will be demand (at cost-covering prices)
for the goods produced. In the oncologist’s case, she might find
gainful employment by working in another branch of medicine
(or, in a worst-case scenario, by waiting tables at a 24-hour dining
Economies consist of millions of products and countless types
of labor. Some of these products will be demanded at certain prices,
others will not. It is just that simple. The key to maintaining output
and employment at high levels is to produce goods and services in
correct proportions to each other. If these ratios of various types of
production are correct, then all products will be sold at prices that
cover their costs of production.
Recessions force companies to use their resources—namely,
labor and capital—more efficiently. As these resources are
reallocated to the changes in market demand, output increases and
employment conditions alleviate. However, if potential workers
are not offering the types of skills desired by employers, or if
their wage and salary requirements are excessive, they will remain
unemployed. Naturally, no one wants to admit that the labor skills
they are offering are 1) undesirable or 2) priced too high. But if we
truly believe Say and the Classical economists, then the onus lies
with the unemployed man to restructure his production, just as
Forty years ago, financial services comprised only 3% of total
U.S. output. By 2007, the sector mushroomed to 7.5% of the
nation’s economy. Instead of building bridges or designing more
fuel-efficient vehicles, mathematicians and engineers had been
recruited to Wall Street, where they designed financial schemes to
put people in homes that they simply couldn’t afford. The reckoning
of an untenable situation was at hand. The economy was enduring
a massive restructuring of its production, and the adjustment
process had robbed millions of other Americans of their livelihood.
The type and cost of production that they had been supplying was
considerably mismatched with the demand for that same output.
As far as my own job loss was concerned, the market clearly
no longer demanded another PR man to furnish an optimistic
assessment of the mortgage market. Accordingly, if I wanted
to retain some capacity to consume, I was forced to produce a
commodity for which a healthy market still remained: namely,
cheap, quality breakfast food. Undoubtedly, the shift had been for
the greater good of society.