Let’s mix and paraphrase Goya and Shakespeare and ask: “When reason sleeps, what dreams may come?” I mix and paraphrase since the sources (Francisco Goya’s aquatint series “Los caprichos” and Hamlet’s soliloquy “to be or not to be”) are not exactly on point. Goya’s man is dreaming, and Hamlet is consciously considering suicide.
I say policymakers the world over have put their reason to sleep but remain awake to do great harm. The harm is better said to be murder of national interest rather than suicide, since some leaders remain present and continue their folly.
Policy in the US and only slightly less so in China allows inflationary increases in the money supply and spendable paper claims to occur, combined with a conscious effort to suppress production via lockdowns. The result is the essence of inflation/recession: added buying power and empty shelves.
In a sense it is already recession or depression, since so many citizens are dissatisfied, even depressed, at their personal economic and social state of affairs.
Everyone using social media has seen and heard the frustrated citizens of Shanghai at night, baying at the moon. In Anytown USA, citizens can be seen cursing the price shown on their gasoline pumps and cursing the politicians as well who are thought to be responsible.
Everywhere there is a sharp reduction in the satisfaction that citizen consumers get from there economic lives, and everywhere there is a deep drop in the profits citizens earn in their productive, working lives. Even when people are “making money” because of real-estate bubbles or stock-market gyrations, citizens understand that such speculative riches may disappear as quickly as they pop up.
The politicians who put their reason to sleep while they were spreading false good times with checks in the mail and business bailouts have good reason to fear lost public support and/or election setbacks. Those worries now cause double-down-style policy actions, in anticipation of classical recession hints in the statistical wind.
OK, there is a lot of economic dissatisfaction around. And it is connected with inflation. But what is the process by which inflation turns into obvious, standard, everyday recession (or worse)?
Price ratios
During inflation, prices for different products increase at different rates, and therefore the ratios between prices change. Some ratios are critical. For example, the price of gasoline may double, while the price of steak at the supermarket might go up by 50% and the wage of the household may increase by only 5%. The householder finds that traditional buying habits must be changed, reducing the overall level of buyer’s economic satisfaction.
In an economy like China’s, with significant elements of central planning and control, many critical prices and price ratios are set externally, in uncontrollable international markets. Producer input prices faced by Chinese planners and firms are now rising at 9-10% a year, making a mess of old plans and forcing firms to make uncomfortable changes to the prices they do control, especially wages and prices paid for locally produced inputs.
(Money wages may not be cut, but the fall in buying power caused by inflation does the job.)
In the absence of such adjustments, the prices that China must charge for the goods it exports must rise, causing lost sales, endangering the inward flow of international money and putting at risk the national growth factor produced by such export earnings.
Likewise, costs of production all over the US economy have risen, and cost ratios have changed, reducing profits and dislocating productive efforts (sometimes because of misguided regulatory shutdowns like the one that caused an artificial shortage of baby formula nationwide).
Bubbles and crashes
One classic process whereby bubble inflation in the stock market leads to recessions is the margin-call crash. Stock-market brokers, who actually hold the stocks “owned” by customers who bought the stock with money borrowed (on “margin”) from the broker, where the stock has been put up as collateral against the debt, will sell the stock and so cash in the collateral during panic times.
This process can occur in any market, any place, China or America. It consists in the forced sale of assets, once bubbling up in value, now falling in price, that were bought in the first place with borrowed money; especially when the lender was a middleman in the deal, and the underlying asset was put up as security for the loan: That security is now gone as far as the lender is concerned, since even if the lender takes over the asset when the borrower cannot pay, the asset’s value is now insufficient to pay of the debt.
The lender, himself strapped for cash, sells the asset, even at a price below “real value,” since nobody knows when the bubble burst value declines seen everywhere will stop. It is the downside panic that too often characterizes the end of a bubble.
An example will help. Investor buys asset at 100 yuan. (Let us say the asset is made of 100 parts, each part initially worth one yuan.) To pay, he puts up 10 yuan and he borrows 90 yuan from his friend. Friend says, “OK, but if you do not pay me when I ask for my money, and I will ask for my money if the asset is not worth at least 90 yuan, I will seize the asset, or some other asset of yours that is worth at least 90 yuan, so I am sure of getting my money back.”
Investor does not worry in an up-bubble, since he reasonably predicts the asset will soon be worth 200 yuan, and he may always sell a part of the asset to settle the debt of 90, and have full equity in a new position. (Since each of the 100 parts of the asset is now worth 2 yuan, investor need sell only 45 parts of asset to get enough money to settle the 90 yuan debt, keeping 55 parts for himself.) Remaining investment is debt-free, worth 110 yuan.
The price ratio that gets out of line in a down-bubble that is especially ruinous and dangerous is the ratio between good investments and bad ones. All investments look bad and all get sold out.
During a down-bubble, the aggregate value of the 100-part asset falls below 90 yuan, the friend cannot get all his money back when he seizes the asset and sells it; although he will do so, and then come back to the investor and demand more money. The investor has been sold out of the original asset and must find other assets to sell to close out the original debt.
Investor may be forced to panic-sell really good assets at give-away prices, just to settle the debt against the bubble asset. This is the process whereby a down-bubble creates universal selling of all kinds of assets, destroying all kinds of value, leading in the worst case, to market collapse and even general depression.
Some changes and price ratios are internal to firms. The operator of a family-owned restaurant discovers that the input prices rise faster than he can pass along to customers and remain competitive.
Say the price the family must pay for incoming ground beef goes up by 15% but the family can only increase the price of hamburgers that they push across the counter by 5% if they are to retain their customer base. That means either profits nosedive or they squeeze other costs: Perhaps they let some of the hired staff go. Such unemployment is another element of recession caused by changed price ratios.
Policy failures
Policymakers see these troubles cascading through the economy: Investors are selling out good assets while lenders are not getting their money back. Small businesses are failing. Ordinary workers are losing their jobs. None of this is ”deserved.” Good investments are dumped for pennies. Dependable workers cannot find jobs. Restaurants that serve excellent hamburgers go out of business.
Policymakers are at a loss. They make matters worse with business bailouts that do not distinguish between good hamburger sellers and bad ones. Unemployment checks go to shirkers as well as hard workers. Bubble asset prices are supported, and worthy assets cannot find buyers.
Everywhere policy mistakes are obvious and give rise to voter/citizen unrest because of perceived unfairness. If and when policy gets things right, there is an overall impression of hit and miss. Policymakers are seen to be right only by chance and so get no credit at all. A general sense of failure and ineptitude prevails, in both private markets and political discussions.
Neither the Chinese way of doing things nor the Western tradition has a good record correcting the many imbalances that comprise an economic order beset by the entwined processes of inflation and recession.
When a “cure” has occurred, there is a return to normal price and value ratios. Then, young couples working at their first jobs can make enough money and have enough employment security to buy their first house or condo without having to ask their parents to pay the unbalanced price demanded in a bubble real-estate market. Small businesses once again pay for needed inputs while charging enough to earn profits required for long run survival.
But how to quickly or easily bring about this normal state of affairs by political means, by planning or by indirect policymaking, is not known. Historically, it certainly has not been done in the short run.
Historically, about all that can be said is that policymakers must reawaken their sleeping reason and stop making things worse. Otherwise, their nightmare dreams will continue to stalk us all.
Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Quebec. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.