The question currently being posed at coffee shops, universities, business seminars an TV is whether our current recession will be bad or really bad – perhaps even a recession. Such speculation assumes that the underlying situation is fine, that we are going through a normal business cycle, and that we shall soon return to a period of ‘normal’ growth. I argue this is most certainly not the case. What we are experiencing is something more like what physics refers to as a phase shift. If you cool water it suddenly becomes a solid – ice. Heat water enough and you have a gas. In other words, I think the economy we end up with on the far side of this downturn is likely to be very different from the economy we have now. Part of my argument is that the current crisis demonstrates that the entire intellectual underpinnings of our economy are wrong and if we are forced to change those, it is likely the economy will be very different.
At least two major assumptions are currently being shown to be dead wrong. The first is the "Chicago School" of economics. This school, which has won more Nobel prizes than any other, assumes, amongst other things, a notion of rational actors. A brief definition is that on average people make pretty good assumptions about the future and then behave rationally to maximize their returns based on those assumptions. I like to think of this as the "everyone is an academic economist" theory of behavior. Any student of history, human psychology, primate behavior, or one’s neighbors and co-workers knows those are two bad assumptions. Not only are people exceptionally poor at predicting the future – astrological reading anyone? – they are really good at ignoring it. I would guess, using a completely random sampling of myself and my friends, that humans spend as much time actively suppressing thoughts of the future as constructing any kind of model to account for it. For every parent who has ever yelled "What were you thinking" and for everyone who has ever had that yelled at them, the Chicago school seems a very dubious idea. Further, assuming we have actually formed some idea of the future, do we behave rationally in the face of our model? Good lord no. The first time you get a high quality hangover and exclaim "never again" you have created a model prediction of the future. Drink too much = suffering. Hence, people never experience second hangovers. And certainly no one has ever had more than two hangovers, that would just be irrational. And certainly we have never, ever, gone out on a date with someone we know, know, is simply going to inflict misery on us. And then we have never done that again. Or eaten so much we get sick, or . . .
You see, we are not rational actors at many points in our lives. One of the aspects we are truly not rational about is money. Money is confusing and stress inducing. Faced with confusing, stress inducing situations, people behave virtually every way except rationally. Treasury Secretary Paulson announced that he was having to look into why banks were not adjusting mortgages when it was in their own best interest to do so. They weren’t, he was pained to admit, behaving rationally. What is the big deal you say? Well the big deal is that the entire justification for a hands off, low regulation economy is that the market, through rational action, will regulate itself. If we are forced to accept during this downturn that we are not rational actors, and I hope we will be, then regulation is not just an option but necessary. Like seatbelts and airbags in cars, they go from being an imposition to a good idea. If we accept regulation as good and necessary then the questions become about the best kind of regulation to implement in all aspects of the economy. That kind of shift is not a slight realignment that will kick the economy back into shape, it is a fundamentally re-orientation of our outlook on the functioning of the economy that will require rethinking virtually every aspect of banking, insurance, taxation, development, etc. Not a return to the good old days, but to the good new days.
Second, and perhaps more importantly, our previous assumption was that our economy would grow without limits based on ever increasing consumption. This idea, which underwrites our Markets and most economic planning, assumes the economy will grow, despite the occasional setback, forever. A company listed on the stock market can sell shares at 20 times its earnings value and be considered a very sound investment because it is assumed that over time, the company will grow and be able to pay back that value. When a companies growth slows, or horror of horror, declines the shares value can drop quite precipitously. Note too that a recession, a few quarters of negative growth – it is actually called negative growth not ‘decline’, ‘shrink’, or ‘fall’ – this is considered a very bad thing. Why? Because growth is considered a necessary and unquestioned good. Every year it is assumed we will produce more, consume more, make more profit, take on more debt, more, more, more! That it is simply impossible to expand everything infinitely for all time seems not to have a very great impact on the popularity of this economic model. The reason it has no impact is because it is such a wonderfully convenient myth. How do you help the poor of the world – grow the economy by making huge investments with big companies. When those companies grow, the GDP grows, and there is more wealth to go around. By creating wealth, we create opportunity, so much opportunity that soon, real soon, everyone, everywhere will have a decent shot at economic prosperity. Read anything from the World Bank, IMF, Chicago School of Economics, and you will see some fancy version of this myth. This is why you have likely read something recently about the terror of American saving. What happens if we save? Well, we don’t consume more and our whole economic model goes right in the toilet. Notice that the argument is not the consumption is good for us, or that we need the stuff we are supposed to be buying. No, the argument is simple, no consumer growth in the economy means no economy.
Of course, this argument is not true. Macy’s is closing stores and reporting dismal earnings, but they are reporting earnings. They are not losing money. They are not making as much money as they thought they would a few months ago and, even worse, it looks like they may be making the same amount of profit, not an ever increasing amount, for a few quarters. It is important to remember here that major companies are not trying to make a profit, they are trying to make more of a profit than any other major company and, hence, attract investment which allows them to make still further profits. If consumer demand does not grow FOREVER the model does not work. Of course the model does not work in the long run anyway, but that is another story.
So what happens if consumer demand simply stops growing? I am not sure anyone really knows. One of the likely outcomes would be an attempt to expand markets outside of the developed world. Unfortunately consumers in these markets often do not have money. People who are living on a dollar a day or less are literally dying for the opportunity to consume more. To get them money, however, would require a massive redistribution of the worlds wealth. Roughly 300 million Chinese live on a dollar a day or less. To increase their standard of living to two dollars a day would require the transfer to rural china of roughly a trillion dollars a year. Whatever else you think of the China and the government, they have done an amazing job of raising the living standards of their population over the last 25 years. Despite their best efforts, they have a long, long way to go and the model they have been pursuing, exporting to American and European consumers, is now unraveling. Further, it is clear we do not have the resources necessary to raise everyone’s standard of living to a Western level. Their will have to be a redistribution of both wealth and resources if we wish to redress current global imbalances in wealth and poverty. In any case, the lie that we can consume everyone to wealth is being shown to be as hollow as the notion that everyone acts more or less rationally in the aggregate.
What comes next is hard to predict. However, I argue that the dramatic unraveling of our economy, and the subsequent unraveling its underpinnings, means that what comes next is likely to be quite different from what immediately preceded it. Change we can believe in indeed.