Causes of Economic Downturns (Recessions and Depressions) – Labor, Capital, and Total Factor Productivity (TFP)

Causes of Economic Downturns (Recessions and Depressions)– Another question of great importance among macroeconomists is what makes output decline or grow more slowly. Clearly, anything that causes labor, capital, or TFP to fall could potentially cause a decline in output, or at least a decline in its rate of growth. A massive earthquake, for example, could reduce output by destroying vast amounts of physical capital. Similarly, a deadly epidemic could reduce output by decimating the labor force. Even something as seemingly noneconomic as religious strife could reduce output, by increasing tensions among employees of different faiths and thus reducing their collective efficiency and, in turn, Total Factor Productivity (TFP).

In some cases, however, output may decline sharply even in the absence of any earthquakes or epidemics. From 1929 to 1933, for example, national output declined by more than 30 percent in the United States. Economists and policy makers alike were as puzzled as they were horrified. President Herbert Hoover observed in October 1930 that although the economy was in a depression, “the fundamental assets of the Nation . . . have been unimpaired. . . . The gigantic
equipment and unparalleled organization for production and distribution are in many parts even stronger than two years ago.” Similarly, in his inaugural address in early 1933, President Franklin Roosevelt maintained that “our distress comes from no failure of substance. We are stricken by no plague of locusts. . . . Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply.” Since all the necessary inputs (labor and capital) were there, why had output fallen so dramatically in just a few short years?

The British economist John Maynard Keynes claimed to have the answer. “If our poverty were due to earthquake or famine or war—if we lacked material things and the resources to produce them,” he wrote in 1933, “we could not expect to find the means to prosperity except in hard work, abstinence, and invention.

In fact, our predicament is notoriously of another kind. It comes from some failure in the immaterial devices of the mind. . . . Nothing is required, and nothing will avail, except a little clear thinking.” His key insight, implied by the phrase “immaterial devices of the mind,” was that the problem was mainly one of expectations and psychology. For some reason, people had gotten it into their heads that the economy was in trouble, and that belief rapidly became self-fulfilling. Families decided that they had better save more to prepare for the future. Seeing a drop in consumption on the horizon, businesses decided to scale back both investment and production, leading to layoffs, which reduced workers’ incomes and thus exacerbated the drop in consumption.

Driven by nothing more than expectations, which Keynes would later refer to as “animal spirits,” the economy had fallen into a vicious downward spiral. Although the economy’s potential output remained large (since all the same factories were still there and the same workers still available, if called upon), actual output had collapsed as a result of a severe shortfall in demand.

In principle, such a collapse could not have occurred had prices been perfectly flexible and adjusted instantly to reequilibrate supply and demand. For example, if wages had fallen fast enough (and far enough) to reflect a reduced demand for labor, all unemployed workers would quickly have found new jobs, though admittedly at lower wages than they had enjoyed before. The point is that even with sudden changes in expectations, resources would never go to waste—or remain unemployed—if the price mechanism worked perfectly.

In practice, however, markets sometimes falter. For reasons that are still not fully understood, prices can be rigid or sticky, meaning that they don’t

always adjust as quickly or as completely as they should. As a result, a negative shock—including a sudden downturn in expectations—truly can drive an economy into an extended recession, where real incomes decline and both human and physical resources are left unemployed.

Starting around the time of Keynes, therefore, economists began to realize that there was more to economic growth than just the supply side. Demand mattered a great deal as well, particularly since it could sometimes fall short. In fact, over roughly the next 40 years, it became an article of faith among leading economists and government officials that it was the government’s responsibility to “manage demand” through fiscal and monetary policy, so as to reduce the duration and the severity of economic recessions and thus help stabilize the business cycle.

But for now it is worth remembering that actual output can fall short of potential output when demand falters. Labor, capital, and TFP are all very important, but so too are expectations.

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