Saturday, April 24, 2010

On Downturns

This is a continuation of the analysis of downturns and managers in Productivity Sense and Nonsense, and More Productivity Sense. In essence, a sizable portion of the economy that was generating, thought to be generating, or thought it would generate substantial profits is discovered no longer, not to, wasn't, or won't, be generating them. Assets may have to be marked down and past investments written off, present ones reduced, and future ones abandoned. May be because these may be dependent on interest rates which may restore or increase profitability as they fall. The economy has had a hole blown in it that cannot be filled in short order.

As we left it, prices and wages are unchanged but quantity and profit has been reduced. In addition, due to fixed costs, profitability has been reduced. In the worst case, this can lead to high rates, loan calls, default, bankruptcy, asset liquidation, mergers, and sale of firms, when values are already distressed, but set this aside for now. Fallen assets and wealth, lowered profits and profitability, and excess capacity and reduced future expectations delay recovery. Prices and wages are sticky, and this can result in unemployment for some time, but this does not cause output to fall or prevent it from falling initially.

Managers would like to sell more to increase their profits and profitability, but as most everything is overcapacity, they can do so only at the expense of others. They may be tempted to lower prices to increase quantity, but this is by no means certain. If their customers come to expect lower prices in the future they may delay rather than accelerate purchases setting up deflationary expectations. Cuts in prices and wages may further intensify this into a downward spiral.

If real wages rose at an increasing rate, buyers would be more inclined to delay, but while sellers may be willing or forced to sell inventory below cost, they are not likely to produce below cost, so eventually price declines reach a limit of wage declines. Prices, initially more elastic than wages, would fall to the point their elasticity matched that of wages. The duration of the production cycle would throttle the rate of decline since sellers will want to make sure their costs are covered. Only when prices and wages have stabilized will the downturn end. At this point, there is little more incentive to delay. If prices fall, wages also fall, and attempts to save more fail as they do so. In this case, rising real wages do not terminate deflation but are triggered by it, and that they eventually cease to rise that end it. So while sticky wages result in unemployment, and less sticky prices can result in deflation, sticky prices and wages eventually prevent total implosion.

Finally employment income and output stabilizes at its new lower level. The workforce continues to increase and productivity rises, leading to increasing output and rising unemployment until output grows fast enough to add more workers than by which the workforce is growing.