A Vicious Cycle
Entry posted by Lord GVChamp
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Economics, like the hard sciences, and many of the soft sciences, is a very confusing subject. And, even when you understand the material, you are prone to making some real, REAL bone-headed moves. For instance, the President of the Minneaplois Fed saying low interest rates cause deflation. The problem is explanations that SOUND good, but, on a more in-depth look, really don’t make much sense.
Today I want to talk about an idea like that. It sounds realllllyyyy good. They teach it as fact in the schools. My dad mentioned it. Sometimes even the smartest people mention a variation of it.
It’s about laying off workers causing a vicious cycle that kills the economy. And this doesn't make sense to me.
The explanation is very simple, yet sounds smart, which makes it so damn alluring. As explained in Michael Moore’s “Roger and Me” by a pissed off GM worker, the process goes like this:
-Big company lays off workers and tells the remaining ones to work harder
-Fired workers no longer can buy products from the company
-Demand falls while supply stays the same
-Company ends up with an excess of goods and loses money
-Company fires more workers to cut costs and tells the remaining ones to work harder
-Process continues
I’ll call this the Michael Moore argument. On the surface, it makes sense. Sort of. There is a clear, internally consistent, logical progression from Point A to Point B. The explanation also has the seduction of unintended consequences, incendiary language (work harder), plays on our heart strings (poor workers!), and allows us to assign blame (stupid money-grubbing corporations). People love it.
Okay, what should we do? Let’s consider the prescription and decide whether that makes sense. Maybe we should do something like Henry Ford and pay our workers enough to buy Model Ts, because it will create a market for our goods (which is what all my elementary, middle, and high school teachers told me). Or we should not fire our workers, because that's mean and will cause us more problems over the long-run.
But this doesn’t pass a supply analysis. Step 1 in this argument says we can produce more with less people, or we can produce the same by paying our workers less. Productivity is a great thing. In fact, it’s pretty much the only thing that matters. Economic growth is driven by productivity enhancements, IE, doing more with less, and labor is a costly ingredient that must be saved wherever possible. So, looking at this from the supply-side, it makes perfect sense to lay off the workers, even from a macroeconomic view, because now they can do something else. Yet this explanation paints the only source of our economic growth as a boogey-man. Robots are bad. ATMs are bad. Factories are bad. The !@#$@#$ Cotton Gin is bad for crying out loud. Anything that saves labor is bad.
Even though this argument makes sense on the surface, it recommends things that are clearly destructive. Destructive in the sense that our entire economy would actually grind to a halt, which is what will also happen if we lay off people. Both options leave us in ruin, which can't possibly be right, either as a recommendation, or just looking at history. Our economy runs into speed-bumps, but our long-term trend is upward, and will continue to be until we run out of resources. So what gives?
The Michael Moore argument makes some broad sweeps that pass over some very important issues. That’s why you end up with the odd effect of the economy getting worse off, even though we are getting more productive. Over the long-run, it’s all about production, production, production (or supply, supply, supply). So let’s take a look at that one.
First, let’s look at our two essential economic elements and figure out which one we are talking about. Step 3 lays it out pretty clearly: this is a demand problem. Supply remains unaffected, while the economy undergoes a negative demand shift from the laid-off workers. Slack, in other words, and this uncontrolled process leads to greater and greater demand reductions till we are stuck in the stone-age.
(Note: There actually ARE supply elements to paying workers more, and I’m sure some of you are thinking that now. “Well-paid workers are happy workers” and Henry Ford reducing absenteeism and so on. I understand this. But the argument, as put forward, is a straight-up demand problem. The actual productivity of the company isn’t declining at all, and people point to the short-fall in demand causing problems. Further, Step 1 just mentions “workers,” and this whole argument would hold true even if you are firing slack-jawed yokels. I’m only talking about this particular demand aspect of the problem.)
The negative demand shift in the economy is caused by a fall in consumer demand, as opposed to business demand, export demand, or government demand. Consumers have less money and therefore are spending less. And right here, we can run into our first problem. There are different sorts of demand. And in this case, the business should run into more money in the short-run because they aren’t paying as many workers.
Business demand should increase. With their new-found profitability, they will be undertaking other projects they could never find the money to do for, like building a new factory or unveiling a new product or a swimming pool for the CEO or whatever. And they’ll need workers, right? Like those unemployed workers they just fired. Bad-a-bing, bad-a-boom, demand shoots right back up and we’re better off when we started. Because money doesn’t magically disappear.
Or we could look at the people who own the company. Shareholders will also be getting more money. And shareholders are consumers, so the fall in consumer demand will be mitigated. The demand will shift, towards things like yachts, and those unemployed workers will find new jobs in those companies. And the demand problem is solved. Because money doesn't magically disappear.
Or the company and the rich people might choose to save their money. But this isn’t bad, it means more resources for entrepreneurs. A high savings rate reduces interest rates and suddenly the next Bill Gates is using that saved money to start the new Microsoft, and hires up all those unemployed worker, and the demand problem is solved. Because money doesn’t magically disappear.
Basically, in any situation, the money doesn’t actually disappear, so demand shouldn't be affected. Even if you come up with the worst-case scenario for the business, which is that they DO experience a loss in cash because their inventory never gets sold, then all that money is going to the still-employed part of the work force. Who will then hire the unemployed to do clean their bathrooms or whatever. Because money doesn’t magically disappear. The US economy is dynamic enough to employ excess cash, most of the time.
We do run into speedbumps, though, and that's because sometimes bad things can happen. Some of the extra money goes to the shareholders, the company, and the workers, but they don’t WANT more stuff. They want to save their money. Only there is no Bill Gates entrepreneur around to use up all that extra cash, and other businesses don’t want to invest either. In the bad case, there’s all this extra cash, but there’s no where to put it. So everyone holds onto it. Or maybe they just want to hold onto their money because it looks shiny or is safer than investing in AIG (sound familiar, Ron Paul fans?).
And even though the money didn’t magically disappear, as far as the economy is concerned the money IS gone, because that money isn’t in the economy anymore. And now demand DOES fall, even though supply should be increasing. Oh. !@#$.
Now we ARE in the vicious cycle. Now there isn’t enough demand for all those inventories, and businesses fire more workers because they don’t need as much, and the process repeats and repeats. We’re in a recession now.
But what CAUSED this? It wasn’t the company firing workers to begin with. That’s a GOOD decision. What caused the recession is money being drained out of the economy. While, over the long-run, money shouldn’t matter at all, short-run changes in the money supply not matched by money demand are the most destabilizing changes that can happen to an economy, short of a military invasion or sudden collapse in resources.
Why? We’ll consider that next week, and it has something to do with Step 3 of the Michael Moore argument. For now, it’s enough to know what’s causing our problems, and that’s the sudden drop in the money in the economy.
You’ll notice we now have different ideas of what we should do, which is the most important part of this post. Should we really tell the company to hire back more workers that they don’t need? No, it’s not necessary. Instead, if the money supply is insufficient, we just print more money for the economy. If people want to save in REAL things but can’t because there is no Bill Gates, then the government will borrow the money and pretend to be Bill Gates for a little while. They will just build bridges and pay the unemployed so they don’t starve, instead of building IT empires.
Now you know what’s causing the problem. In the long-run, it’s production, production, production. In the short-run, it’s money, savings, and investment. Look at those three things, and you’ll have a better concept of how short-run fluctuations work and what we should do to fix them.
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