Sunday, December 27, 2009

A Theory of Depressions

In an economy in equilibrium, demand and supply are in balance. It may be growing with population and productivity, stable or even declining if they decline. The economy may grow out of balance gradually due to mistaken expectations of profits, or momentum investing fashions, or the accumulation of debt that cannot be repaid, and turn on an endogenous shock when these expectations are dashed, or it may be happen suddenly when struck by an exogenous shock. The shock leads to reductions in investment and employment in the affected areas, reducing demand. Prices initially are more elastic than wages which can lead to real wage rates rising even as total real wages fall. This creates an incentive to delay spending for lower prices and even higher real wages creating deflation. While prices are initially more elastic though, and sellers may be willing or forced to sell inventory at or below marginal cost, they are not likely to produce below cost, so eventually price declines reach a limit of wage declines. The duration of the production cycle would throttle the rate of decline since prices must eventually cover earlier incurred wage costs. At this point, there is little more incentive to delay. Prices fall until price elasticity matches wage elasticity. If prices fall, wages also fall, and attempts to save more fail as they do so. In this case, it is not rising real wages that terminate deflation, but that they cease to rise. At this stage deferred spending picks up and along with it production, employment, and total wages. It does not necessarily pick up where it was before soon though. Even if bad debt and bad investments have been written off, there may not be anything else to soon take its place, and while real wages may no longer be increasing, they are likely still too high for full employment. Inflation helps by allowing real wages to fall and employment grow.