Why Recessions are Actually a Good Thing

Since the financial crisis in 2007-2008, The U.S. economy has been on life support; banks were bailed out, the Fed lowered interest rates, and the money printing began. Like a heart attack patient receiving shocks from a defibrillator, QE1, QE2, and QE3 began in rapid succession to support an ailing economy. Our government, particularly the Federal Reserve, did everything it could to prevent Great Depression 2.0, but did it really cure the disease or just pump us full of morphine? Has the economy actually improved or has cheap money simply allowed us to forget the pain? Sadly it’s the latter, and even more unfortunately, when the morphine wears off this time, there won’t be any saving this economy.

The Fed kicked the can down the road in 2008 instead of allowing the economy to properly rid itself of previous imbalances, and in doing so, they set the U.S. economy up for an even worse economic crisis. Unfortunately most people, even financial “experts”, are oblivious to the reality of the situation. The goal of this site is to educate people from all backgrounds and levels of knowledge about the true workings of an economy, why the grow, and why they fail. I see this first post as an opportunity to explain one of the most misunderstood concepts in modern economics: the business cycle.

Business cycles are a described as a expansions and recessions; periods of growth and periods of contraction; times of wealth and times of welfare, but contrary to popular belief, booms and busts are (in large part) non-existent in a capitalist economy that is absent of central government planning. Central banks actually create the boom-bust cycle and unfortunately capitalism gets a bad reputation for the problems that emanate from central bank policies. So how exactly do they create this cycle? The answer lies in interest rates.

The Federal Reserve has various objectives and roles in our economy, one of which includes setting interest rates through the process of open market purchases. As the central bank, it has the ability to influence the overnight lending rate (the federal funds rate) between banks through the purchase of U.S. Treasury bills which in turn affects other interest rates in the economy. By purchasing these assets, the Fed pumps money into the economy and simultaneously lowers interest rates (keep an eye out for future posts for a more in depth explanation of how this process actually works). Lower interest rates are meant to stimulate growth, higher rates are meant to keep inflation low, and if you haven’t noticed yet, herein lies the problem. These types of policy arrangements rest on the assumption that bureaucrats in Washington know better than the market when it comes to determining interest rates.

You see, interest rates are price of borrowing money, and just like the price of any other good or service, they are determined by supply and demand (Note: other factors help to determine interest rates as well, but basic supply and demand underpin the entire model). The savers provide the supply and the borrowers create the demand, resulting in some equilibrium interest rate. The more savings there are, the greater the supply, the lower the interest rate, and vice versa. When the Federal Reserve artificially lowers interest rates to promote economic growth, they create the illusion of excess savings available to finance the money that is being borrowed even when no such savings exist. These low interest rates promote  excessive borrowing and consumption that lead to malinvestment on the parts of market participants (housing bubble, anyone?).

To understand exactly how the Federal Reserve creates such a cycle, let’s explore the very policies that left us  with the crippled economy we have today. In the early 2000’s, the Federal Reserve lowered interest rates in an effort to get us out of a recession following the “Dot Com Bubble” and the September 11th attacks. The Fed’s low interest rates did exactly what they we’re supposed to and within less than a year the economy was back to full output, but those low interest rates did exactly the same thing they’re doing now: numb the pain. Instead of allowing a true recession to take place and forcing land, labor, and capital to be reallocated to the most efficient sectors of the economy, the Federal Reserve gave us a quick dose of morphine and refused to admit that there was a serious underlying problem.

As you can imagine, all the cheap money that the Fed was printing following that recession came back to bite them in what eventually became the housing bubble. Easy money, along with a variety of other factors, gave way to excessive borrowing on the parts of Wall Street and Main Street alike. Rational investing went out the window as soon as the morphine kicked in, but when the low-interest rate “high” ended, we began to wake up to reality and  what we were left with was a financial crisis that nearly rivaled the Great Depression. Here’s the thing that central bankers will never understand and it’s why economies malfunction: the problem with using cheap money as a means to grow an economy is that money doesn’t stay cheap forever, and if it does, it’s worthless. Savings and production are the key to growth, not consumption and excessive borrowing.

Today we have interest rates that are more than just low; they’re zero! The Federal Reserve has yet to learn from it’s mistakes. They’ve instead chose to increase the magnitude with which they implement the same policies which can only mean that this, too, will come back to haunt them. Ben Bernanke and the Federal Reserve get a lot of praise for having “saved” the economy; they prevented an even worse crisis from occurring when the housing bubble burst. But what did they really prevent? They prevented an economic restructuring from taking place; land, labor, and capital were never reallocated. That is why recessions are actually a blessing in disguise: as painful as they are, they allow the proper adjustments to take place so that we may begin to undo all the mistakes/poor investments that were made during the phony expansion. It may be painful for quite some time, but if we actually want to fix our problems we need to be willing to bite the bullet.

Eventually we’ll have to face the fact that our economy has too many structural imbalances to be viable for much longer, and when the morphine wears off, a crisis lies ahead. But only then can the healing process begin. Only then can we once again become a wealthy nation. If only we can embrace true and unbridled capitalism, will we all be better off.

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