On Depressions, the Structure of Production & Fiscal Policy

I came into economics and finance blogging in 2011 a very different economic thinker than I am today. I was convinced (and remain convinced) that we were going through a once-in a generation economic transformation, or more accurately an industrial revolution the shape of which remained uncertain. These ongoing industrial revolutions, of course, cause great upheavals. As Joseph Stiglitz has noted, the Great Depression of the 1930s can be seen as a great displacement of labour in agriculture thanks to technological improvement. Stiglitz, like myself, sees a parallel between today’s slump and that of the 1930s; in the 1930s we were transitioning out of agriculture. We are also in a transitional period today. Since the advent of globalisation, and the growth in automation in the 1970s and 1980s society had begun suffering from falling real wages, and had had to lever up on debt in order to sustain lifestyles and spending habits. The financial sector had taken advantage of this, offering cheapish debt and — morally hazardously — securitising these debts and selling it a greater fool. This was a bomb waiting to explode — because lenders did not have to take responsibility for the fruits of their lending, they could lend to any NINJA, pay the credit rating agencies to grade highly speculative debt as AAA-grade, and sell it to another bank, or a pension fund, or a hedge fund. When the financial crisis blew up, I desired very, very strongly to see the entire corrupt market liquidated. This was an entirely Darwinian wish; financial firms had acted irresponsibly, creating a monstrous system that nobody really understood and they should pay the consequences for their irresponsibility. In liquidation, people would learn a harsh lesson and the economy would be forced to adapt to the new reality. In Hayekian terms, I thought that the structure of production ought to be left alone to adjust.

So I was furious to see the financial sector bailed out and rescued, and I strongly suspected that such medicine would have very harsh negative side effects as the speculators had been rescued instead of learning their lesson the hard way. Maybe the bankers and financiers who got bailed out — and the regulators who were found to be asleep at the wheel — have not learned a lesson. We shall see. Yet, when push came to shove, governments and central banks chose to save the system instead of watching it burn to the ground and given the complexity of the system, and the danger of good businesses being destroyed alongside the speculators and shysters, that is an entirely understandable decision. Certainly, it was also a morally questionable decision — after all, while bankers and financiers get bailed out in an emergency, help for the much poorer fringes of society is much less forthcoming. Yet this is the world in which we live in.

Of course, the world goes on. Banks may not have been disciplined, but the structure of production still must adjust to the new world, albeit in a less brutal and immediate fashion. This has been far from simple. Even though the financial system was saved, economies around the world remained in a depression. In fact, I would define an economic depression in these terms — a depression as opposed to a transitory recession, which relatively quickly self-corrects is a situation in which the structure of production cannot adjust itself back into a pattern of growth, and economic activity becomes permanently lowered. In Britain and the Eurozone we are so far behind our pre-crisis trend that we still as of October 2013 have not grown our way out of the trough yet, let alone caught up with the long term trend line:


The causes of this are multiple and complex. We are in an the midst of an ongoing industrial revolution, a great whirling flourish of creative destruction in which both foreign labour and automation are displacing both manufacturing and increasingly service industries. This creates real ongoing instability. Furthermore there remains the fallout from the crisis — confidence in new job-creating and growth-creating business ventures may have become inherently depressed, as economic expectations drift lower and lower in the context of low growth. Then there is the ongoing trend of government austerity, taking money and jobs out of the economy. Energy prices remain relatively high by historical standards, as we rely on old and increasingly expensive oil-based infrastructure (although I expect energy costs to begin to fall as we transition to newer energy architectures). The private sectors in most Western countries remain in deleveraging mode from a very large private debt overhang from before the crisis, limiting their consumption and investment and paying down debt. These are just some of the possible causes of depressed growth and elevated unemployment that we see.

Governments particularly in Britain and the Eurozone have attempted to fight depressed growth using austerity policies (in the context of expansionary monetary policy). The proponents of austerity theorise that by promising to bring down taxes and spending, they will unleash private sector spending by reducing future expectations of taxes. To me, this has always seemed like a boneheaded and Rube Goldberg-style approach. Simply, the issue of depressed private economic activity is far more complex than future taxation expectations. And aggressive monetary policy has not succeeded in reversing the depression(even if it has probably made the depression less severe). So it has been entirely unsurprising to me to see this approach largely failing. I approach the problem in a far more direct manner. The solution to lowered growth and elevated (and involuntary) unemployment is relatively simple. Eventually someone will start using up the idle resources. This will either be the private sector once it independently gets over its slump in animal spirits, or it will be the government. With such huge volumes of idle capital, interest rates will remain very low until stronger appetite for credit re-emerges. In equilibrium theory, the low cost of credit will by itself start to re-energise borrowing appetite by making more projects potentially profitable. Of course, interest rates are far from the only factor that borrowers take into account when seeking credit, and so it is perfectly plausible that the economy — as it has done — can remain depressed even with very low rates due to deleveraging pressures, low expectations and low confidence, etc. So if the market is ill-suited to taking up the idle resources any time soon — lying as it is in a depressive, irrational strop — the only agent that can do so is the state. The fact of low interest rates allows this to kill two birds with one stone — the state can borrow money (utilising idle capital) to create jobs (utilising idle labour), raising interest rates and bringing down the unemployment rate. And this approach does not require anyone to make accurate predictions about the future. It simply requires a market economy, and a state willing to employ idle resources when they are idle, and to ease off using idle resources when unemployment becomes low and interest rates start to rise.

Many — including probably Hayek himself — would argue that using up idle resources in such a manner will not allow the structure of production to adjust to the new economic reality. The state, Hayek would argue is a poor allocator of capital because it lacks the informational efficiency of the market. I would mostly agree with Hayek’s objection, and note that I favour a predominantly market-based economy. Government interventions should be kept to a necessary minimum. Yet, in a depressionary environment, the structure of production deteriorates as resources lie idle. Unemployed workers lose skills, lose competitive edge and spend and invest less, further depressing the economy. Capital — factories, buildings, amenities, ideas, etc — deteriorates. Young workers may enter the labour force but never find a job. Crime rises, and shady fringe businesses like loan sharks thrive as the unemployed struggle to pay the bills. The social costs of mass unemployment are exceedingly high. The adjustment occurring in a depression is more like a rot. And it is absurd to rot your way to growth. Instead, by lowering unemployment and using up idle capital (preferably in a mix of state-run infrastructure and technology projects, and lending to new businesses) more businesses can be born into existence. Potentially successful new ideas can be tried out, and may find success in the marketplace. The formerly unemployed get to develop skills, habits and ideas, instead of sitting at home all day doing nothing, or hunting for jobs in a scarce and depressed marketplace. And money will go into people’s pockets, spurring investment and consumption, fomenting more new business growth. This, in my view, is the best shot at getting a depressed and rotten structure of production out of the doldrums and back toward strong organic growth. Sooner or later, of course, the private sector will come back and begin to use up resources. But that could be a very, very, very long way away. If we want the structure of production to adjust to the new world and to continue adjusting as the world continues to change, letting huge quantities of resources sitting idle seems like a bad way to do it. Targeted fiscal policy can change that.

35 thoughts on “On Depressions, the Structure of Production & Fiscal Policy

  1. Although it might seem to make sense to start burning the furniture [in a cold house without a conventional heat source], soon the furniture will be gone and you must start taking the walls and floors apart [to burn], as well.

    This, of course, becomes a increasingly questionable strategy with time.

    The best solution is always in fixing the problem [getting rid of the debt], not in destroying productive resources [throwing good money after bad].

    If the basic structure of the economy can not be re-worked properly [as is the case in today’s fascist environment], then it hardly matters whether you suffer more now or later, as re-structuring will arrive when there is little other choice, the way it generally goes down in history.

      • Well, you have a situation where the economy is not functioning properly for several reasons, two of the most important being debt and the financialization process itself This has created a disincentive for productive capital to be employed in wealth producing activity [hiring labor], as well a drain on the freeing up of private capital [going instead to service debt].

        The result is the accumulation of non-productive capital in the hands of those disinterested in its productive use, therefore, low employment.

        So, what is the answer to this problem, getting the government to create unproductive jobs by draining more potentially productive capital through collecting more taxes [burning the furniture]? Even if you highly tax the financial sector to this end, you are still employing potentially productive capital, unproductively.

        I would suggest that it is better to allow the system to completely implode than it is to subsidize its death throes. So, I would do what is necessary to provide basic services for the disenfranchised but not add one government job.

        Government is ALWAYS the problem, and NEVER the solution.

  2. Overall, a good theory. Except for one flaw. You said “It simply requires a market economy, and a state willing to employ idle resources when they are idle, and to ease off using idle resources when unemployment becomes low and interest rates start to rise.”
    It has been my experience (backed up with a great deal of history) that once the State expands, it never eases off. This is due partly because of the tendencies of bureaucracies to protect their turf and partly due to the public’s tendency to demand more from them.
    There is a game played near the end of each fiscal year in which government agencies go on a spending spree to use up all of their allotted budget excess in order to justify demanding an increase in the next year.
    And then there is the unquenchable thirst of the masses demonstrated by the increase in applications for food stamps and disability payments that we have seen in recent years. Most of the recipients of such largesse are unlikely to surrender those benefits, even if the economy improves.
    Theories fail when they encounter human nature.

    • Just because ideas that work in theory are often implemented badly and unsuccessfully doesn’t mean that we should abandon ideas that work in theory and adopt ideas like austerity in depressions which work neither in theory nor in practice.

  3. Well, forgive my informality. You have good thinking skills, however too much belief in State altruism… The State is now more akin to the 11th century style, with laptops… they operate to control the masses for the masters,, not find jobs for our happiness..

    Good day my friend … my book on all this is at 200yearsofcentralbanks.com for a free read…

    regards TM Cole

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      • I would agree with you on reallocation, but only in regards to physical land, seeing God created man to live, breathe and do good works. Land ownership is fundamental to liberty, motivation, and production, as Jefferson well understood. Even Google has to have physical land for their server farms. Governments would be wise to promote widespread distribution of physical land, not promote its conglomeration through LLC law and legalization of long term debt. Physical land is a means of production. Even if not farmed, land can be leased out. Yet the “fruit” of man’s labor is legitimate property and as such should be protected by law. Reallocation of fruit without the individual’s consent is theft and “you shall not steal”. Consequently, widespread innovation, production, and employment will only come about with widespread distribution and ownership of physical land. This was a lesson the colonial founders of America had to learn.

  5. As Paul Anthony points out and you and I have discussed before, this doesn’t work because the state will not wind back its growth when things get good again. Just look at the taper/no taper song and dance. Remember, these theories all sound well and good but leave out the very real existence of political expedience. In the same way that a government surplus will never be held for a rainy day but will be eliminated and returned via tax cuts/credits, so also the state will not eliminate a bunch of workers just because unemployment gets low.
    Look, theoretically I agree with you. This all works on paper. It doesn’t, however, work in reality.

    • Just because government often ends up failing to successfully enact policies that work in theory, doesn’t mean that government should stop trying to enact policies that work in theory and start trying to enact policies that don’t work in theory.

        • Don’t be so sure it is any different.

          Technology being equal, perhaps the serfs felt considerably more secure [a much better measure of well-being].

      • This has been a thought provoking post. I think we assume too much of what we see today as “inevitable”, failing to see to the “funnel” that prior law has created. We think we are technologically advanced when in reality, technological advancement and diversity has been greatly hindered by the limitations placed on us by laws “funneling” everything through highly capitalized large-scale business. Law can promote small-scale business just the same as it has done large-scale, although I’m not sure they can both be promoted at the same time. It would be interesting to see what a world in which small-scale business was promoted would look like. I think we would be pleasantly surprised.

        • “We think we are technologically advanced when in reality, technological advancement and diversity has been greatly hindered…”

          Technology is relative and does not matter, as it will always, “be better,” which means that it will NEVER be better.

          Technology is what keeps people on the wheel, forever hoping that just one more [fill in the blank] will deliver them from the misery of modern life and its loss of individual freedom people yearn for [so desperately].

      • Sounds like a false dichotomy and a little question-begging. Why should the government be enacting policies to alter the economy in the first place?

        In theory, practice and theory are the same. In practice, they are not. I agree with you at a theoretical level. At a practical level, it’s pollyanna.

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  7. Impermanence: I did not mean to imply that technology should be valued more than freedom, but to simply point out that technological progress—and freedom—has been greatly hindered by our “legal promotion” of large-scale business.

    Most have been taught to look at large-scale business as inevitable progress, providing cheaper and more advanced products. This is a narrow, false and deceptive view. Large-scale business is a creation of law. Large-scale business simply shifts costs to other areas. These costs involve loss of freedom, employment, environmental damage…and hindered technological diversity and development.

    Greater freedom, employment, and responsibility—social health—would be achieved through the legal promotion of small-scale business. Not to mention, technological development would blossom.

    • Freedom has been sacrificed at the alter of technological advancement because technology is the engine that powers capitalism.

      Without technology, capitalism will stall; yet without this “advancement,” people would be much better off [making do with what they had instead of believing that a better life can be procured through “better” stuff].

      This is perhaps the greatest ruse of our era.

    • “Greater freedom, employment, and responsibility—social health—would be achieved through the legal promotion of small-scale business.”

      As paradoxical as it may seem, it is any [every] legal system that destroys freedom.

      Once you go down that road [embracing a code outside of individual control], you trod a path so well-warn at this point that one must consider it human nature to covet the notion of stealing from others [what the law is] as the main occupation of our species.

  8. Nice Post Aziz,
    As always I agree 100% with Impermanence’s points.

    After 5 years and counting I truely believe that the irresponsibility of the financial sector was allowed purposesly to run its crazy trend. And what i see in Aziz’s chart is a the 3rd world war fought on the soils of Eurpoe once again. TBFB of the US bailed out by tax payers, Finanical markets in major economies affected, austerity instilled all over the europrean continent, with the weaker nations raped by the IMF (USA), to maintain the crappy system which we have.

    The finanical market made money on the upswing pre 2008 and is making money on the down swing post 2008. The have not been punished but in reality are being rewarded to steal money in new nice ponzy schemes.

    How i see it? Is what Imermanence’s states. A stealing of freedom. A stealing of all value, state, private, realestae, labour value, energy. Everything to the point which we truely are in a feudal state of economy. Tell me if there is any western nation which any of us actually own something. Everything is taxed and is controled by taxed and regulation (with exception to the financial sector) to the point where we work and live to feed the sick financial machine. We simply do not dare to speak of this outloud. We are constantly bombarded with what the left, right, democrat, republican, green etc say to improve the current situation. Nothing is purposely getting done as so the stealing continues and allowing people to believe that they will still maintain ownership of what they think is theirs.

    What we have is what “they” allow us to have. If you think you are free or have the right to contemplate your freedom is only because they allow you to think you have freedom or freedom of thought.

    Yes, eventually things will improve and the crisis will die down just like the war on terror, but it will die down or economies will improve only because they will allow for this. Until the next scheme crisis to be created to keep people of the masses occupied with.

  9. “The formerly unemployed get to develop skills, habits and ideas, instead of sitting at home all day doing nothing”

    Who are you to put a value of 0 on people’s leisure?

  10. This response is a bit late, but I think this is one of your best posts, even if I don’t agree with it fully. Stiglitz is really onto something with his analysis of the Depression, and there are strong parallels to today. I’ll definitely have to chew on this over the next few days.

  11. Aziz,

    Re your conclusion, I’m baffled as to how “targetted fiscal policy” can sort out the “rotten structure of production”.

    Of course, if the authorites are omniscient (and advocates of central planning like to think that) then your solution might work. E.g. if the “rotten structure” consists of too few plumbers in Hastings, and not enough investment in widget productiog in Birmingham, etc etc, then the authorities might be able to do something about that. But of course the authorities just don’t have enough detailed information to put that right.

    • It can’t sort out the rotten structure of production by itself. It can ease the long, difficult process of adjustment by keeping the unemployment rate relatively low and keeping people out of poverty.

      • Won’t, “keeping the unemployment rate low,” make what is, “keeping the unemployment rate high,” worse?

        Government spending is so high that it is stifling what’s left of the private sector. In the U.S., small business has been almost been taxed out of existence.

        It is small business that will lead a true recovery/create jobs.

  12. I hope you do a post on education sometime. The current schooling model is based on a factory: punctuality, attendance, and repetition are prized above all else. Independent thinking won’t guarantee an A, but sacrificing enough “right answers” on the examination alter will.

    This model was barely adequate for the manufacturing age, but it is a complete mismatch for the knowledge economy. To produce the appropriate labor force for the future will require a freer, more creative education system based on learner autonomy.


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