Wednesday, March 11, 2009

Of Wild Fires and Recessions

Everywhere you look these days is economic doom and gloom: lay-offs, bankruptcies, foreclosures. However, it is important to understand that recessions are the way in which free market economies restructure themselves and prepare for the next phase of growth. It is actually a very dynamic, if painful process, by which available resources are reallocated more efficiently.

Take for example the construction industry. For years it was common wisdom that house prices are a one way ticket to riches. People everywhere invested in real estate not so that they could live in a house, but for the financial returns that they expected to generate from such an investment. Such influx of capital, drew ever increasing amounts of our economic resources. Since people act according to their economic incentives, more businesses got into real estate, more people became real estate brokers, more construction and financing jobs became available. In short - more economic resources were allocated to real estate than were needed to support the underlying economic need, i.e. houses for people to live in, as opposed to houses for investment purposes.

Once the real estate bubble burst, houses reverted to what they truly were: places to live in. With the disappearance of the financial incentives to invest in real estate,  all the jobs, money and business that were flowing into that market, are rapidly shifting out. Some are shifting by choice, and some are being forced out as overcapacity mercilessly cuts prices, financing and jobs.

The same process is occurring in many other industries. From manufacturing to airlines to finance and hospitality. The causes in each industry are different, but the effect is similar: capacity is being destroyed. While the situation looks bleak right now - the seeds for the next expansion are being sown as you read these lines. While many firms will go under and unemployment rises, the businesses that survive find themselves strengthen by reduced competition and by lower input costs, as materials, labor and equipment all become cheaper in a downturn. Workers will be cut from industries suffering from overcapacity and from under-performing firms, but will be hired by ones that are healthier. This transition will take time and will no doubt involve a great deal of heartache.

Much like a forest fire is scary and devastating but in the long run is critical to the health of the forest, recessions are the way in which market economies weed out the weak firms and restructure themselves, preparing the ground for a new economic crop. The job of government is to make this transition less difficult, not to stop it from occurring. As firefighters have come to recognize in recent years, the longer you delay a fire from burning the more devastating it becomes when it finally breaks out. The re-adjustment must be allowed to happen. Weak firms must be allowed to go under, over capacity needs to be cut and prices must be allowed to find their natural equilibrium. A controlled burn is better than a raging inferno, so I am not advocating the government not interfere. I am only saying, the government should be a vigilant fire marshall, minimizing the damage from the fire but above all considering the long term health of the forest.

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frugal zeitgeist said...

Outstanding post, as usual.

Shadox said...

Much obliged, Ma'am.