Tuesday, February 10, 2009

Recession: Downward Spiral or Needed Correction

There are two competing views of the current economic slump – one sees the slump as a bottomless downward spiral. According to this view, one business closes, which creates unemployment, which means less consumption, which means another business closes, leading to more unemployment and less consumption, and so on down, down, down. The second view sees the slump as a “correction” during which bad investments are revealed, businesses close, unemployment rises but, if left alone, the economy recovers as individuals work and invest to improve their lives.

According to the “spiral” theory, only swift action by the government can halt the downward slide. Massive government spending and the creation of lots of new money will cause new spending, which will create jobs leading to more spending, which will lead to even more jobs and more spending, and so on. In short, government action creates an upward spiral to replace the downward spiral...

Here’s why the spiral theory is wrong:

First, the spiral theory ignores the fact that the things that we consume usually need to be produced. For instance, hot dogs don’t just materialize at the store. They have to be produced, which means factories have to be built, livestock has to be raised, land has to be dedicated to livestock, feed for livestock must be grown, etc.

All of this production requires time and resources, such as machinery, trucks, plastics, etc. These resources are “capital” goods, meaning they are not for consumption but for production and capital goods require real savings...

All economic booms caused by printing lots of new money must end in a bust. They will end when entrepreneurs discover the lack of real savings or when monetary authorities become concerned about inflation and stop the flow of easy credit. An economic boom based on massive public works projects also will fail because the funding for those projects either comes from present or future taxes, meaning savings or spending is merely diverted from other areas, or it comes from printing money.

The free market works because people want to improve their lives and will invest, work and study in order to make that happen. It is not necessary for government to print money, block imports or spend massively on roads and bridges for this to happen. In fact, when government takes those actions, it encourages poor investments and diverts productive resources away from good investments.

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