These days, there is talk of a recession: A foreboding conclusion many economists and market experts seem to draw from a slowdown in economic growth. Of course, doom and gloom narratives outsell a rosy picture any given day. However, a slowdown in economic growth is not always a recession. To understand this truism, it is important to understand the inverse of a recession, i.e., expansion or an economy in growth mode.
Think about the economy of a country as a human body running on a treadmill. The runner keeps accelerating or increasing the pace of the machine or the incline (slope) until the heart can no longer take any more exertion. Simply put, therefore, an expansionary or growing economy is an economy chasing its full potential.
The difference between an economy’s actual output, measured in terms of its Gross Domestic Product (GDP), and its potential output also measured in terms of GDP is known in economic terms as ‘slack.’ Slack is nothing but unutilized potential. When a jogger starts jogging on the treadmill, let us say his initial jogging speed is his actual output at time t-zero. When he starts accelerating, he is chasing his full potential. Finally, when he reaches a point where his heart says no more, he is said to have realized his full potential at time t1. This difference is what we call expansion, or chasing full potential.
For an economy, this slack can be un-utilized factory capacity, idle capital or unemployed labor. Most commonly, employment is taken as the gauge of an economy’s health. If the economy is operating at less than “full” or at less than its “natural” level of employment, it is said to have slack or potential. As the economy starts chasing its full potential, the slack reduces and the economy becomes tight until inflation rises to such a level that growth is no longer sustainable, i.e., it becomes too expensive for people to buy their gas, groceries and other needs. In other words, the economy says no more running, it is time to slow down.
By now, it is obvious that understanding the functioning of an economy is more art than science. For instance, the Federal Reserve estimates the natural level of employment for the U.S. economy as an unemployment rate between 4.5 to 5 percent. The rate of unemployment, calculated as the percentage of labor force, which is without a job, is a guidepost and not a figure cast in stone. The government has to use a yardstick to determine its policy measures.
Let us understand this from a practical standpoint. The unemployment rate in the U.S. for December 2018 was less than 4 percent. If we step into the shoes of the Federal Reserve, there is no slack in the economy. In fact, the economy is in the danger of overheating. In economics, this simply means a rate of inflation that is too high given the situation the economy is in. Obviously, if the economy has surpassed its full potential, it is time to slow down or reduce the rate of inflation otherwise prices may rise so high that people can no longer afford to buy necessities. In extreme scenarios called “hyperinflation,” people can be out on the streets and in the throes of overthrowing the government—a tragedy observed in Venezuela recently. To slow the economy down, the government reduces the flow of money in the economy just like the heart would reduce the blood flow to our jogger on the treadmill. The Federal Reserve will start increasing the interest rate just as the current governor Jerome Powell has.
As interest rates rise, borrowing from the central bank becomes expensive for banks. In turn, banks reduce the flow of money by increasing the interest rate for end consumers. Thus, consumers cut down on some of their expenditure because the price of money, i.e., interest is higher. Another way of reducing the flow of money is when the Federal Reserve starts selling bonds issued by the government and makes it mandatory for banks to buy those bonds by increasing the amount of money (reserves) that needs to be mandatorily invested in government bonds. Thus, banks are coerced into buying the bonds and money flows to the government which means less money in the economy chasing goods and services and less inflation.
Philip Slater, an American sociologist and author of the nonfiction classic The Pursuit of Loneliness, remarked in 1970 that, “our economy is based on spending billions to persuade people that happiness is buying things, and then insisting that the only way to have a viable economy is to make things for people to buy so they’ll have jobs and get enough money to buy things.”
Although this is a very dark take on capitalism, it describes a growing economy in less than humane words. In an expanding economy, factories, money and labor are all chasing their full potential. In other words, factories are churning out products, hiring people and making profits which are re-invested to make more products. Money is in abundant supply and is open to taking on more risks. This sparks an investment frenzy and people are willing to buy extremely risky investments including stocks of tech companies they do not understand or cryptographic currencies such as Bitcoin. Employed people enjoy higher wages and expect to enjoy even higher wages. This affluence is used to buy more things which means manufacturers, service providers, and builders are prompted to do more business.
The dark side of continuous periods of growth is complacency or an unhealthy feeling of invulnerability. People start believing in fairy tales and unrealistic valuations and buy stocks at very high prices. What constitutes a “very high price” is again a matter of judgment measured by a famous gauge in investing called “the Price to Earnings (P/E) ratio.” It is expressed in the form of the price of a stock divided by the company’s earnings or profits per share. If a company’s P/E ratio is very high relative to the aggregate P/E ratio of the industry it operates in, it is a good sign that the company may be overvalued. Therefore, for any investor in a growing economy, it is important to understand the fundamentals of a business, i.e., how it makes money, how much cash it generates and what gives it an edge to continue to make outsized profits. The good thing about a growing economy is that there could be plenty of less rewarding but less risky investments such as certificates of deposits, savings accounts, and government bonds.
An economy, just like the human body, is incredibly complex. Theories about the functioning of the economy abound each with its own fair share of assumptions and fallacies. To explain the workings of a country using theories is the subject of volumes of literature on the topic. It is very hard to condense extremely complex theories into an easily digestible form. Simplicity, therefore, has been the ultimate objective of this exploration. Also, every explanation is incomplete without looking at an economy in recession. The slowdown in the growth of the U.S. economy is a natural result of recovering from cutting the slack that existed in the economy. It is by no means a guaranteed recession. It could be pointing towards a likely possibility of one. However, a prolonged deceleration would signal a recession. The last essay in this mini-series will explore an economy in recession.