This article is from the March/April 2009 issue of Dollars & Sense: Real World Economics available at http://www.dollarsandsense.org

This article is from the March/April 2009 issue of Dollars & Sense magazine.

Dear Dr. Dollar: I learned in my economics classes that in a market economy, problems tend to be self-correcting: when a recession starts, demand weakens; then prices drop, people and firms start to buy more and the economy picks up again. So why don’t we see this kind of self-correction now? Why does it seem as if things are getting worse and worse?

—Corina Chio, Los Angeles, Calif.

Life, it turns out, is more complicated than the way it is presented in many economics classes. “More complicated” means different.

One of the key differences between reality and the standard fare of some economics classes is that the standard fare does not take sufficient account of the time lapses between one event and another. These time lapses don’t simply mean that adjustments take longer; they mean that the nature of those adjustments can be very different from what one learns in class.

When demand weakens, prices do tend to drop, but they don’t drop immediately. So, for example, when demand weakens and people buy fewer cars, candy, cardigans, and computers, the prices of these goods don’t fall right away. But, facing the fall-off in purchases, the firms that make these products cut back on production and lay off workers. So demand falls further because the unemployed have less money to buy all these products. In this situation, things can get worse and worse instead of being turned around by the falling prices. Which way things go is not automatic, but depends on the seriousness of the initial fall-off in demand and the speed with which that fall-off occurs.

A further problem with the simplistic analysis presented in some classes is that people’s buying decisions are based on expectations about the future as well as on current prices. If auto dealers try to get me to buy a new car by lowering the price, I am not likely to respond positively if I think I may well lose my job soon and be unable to make the monthly payments. And if my main use for a car is to get to and from work, my expectation of lack of work will make me even less likely to buy a new car regardless of the price.

Firms behave similarly. Why should a firm hire more labor or invest in new plants and equipment if the firm expects that people will be cutting back on demand for the firm’s products? Even if interest rates and the prices of labor and raw materials are all falling, firms are unlikely to expand operations if they do not think the demand will be there. Indeed, it is precisely the falling prices that signal to firms that a recession is developing—which means that demand will not be there.

Worse: as prices fall, both consumers and firms are likely to delay purchases, expecting that things will be even cheaper if they wait. But by waiting (i.e., by not spending) they create even more downward pressure. So falling prices (deflation) can make things worse, not better.

And even worse still: because consumers and firms act quite rationally in this manner—cutting back expenditures because they expect things to get worse—things do get worse! When each firm and consumer acts rationally in response to negative expectations, as a group they tend to insure that those negative expectations will become reality. Individual rationality and social rationality come in conflict with one another. This phenomenon is often referred to as “the paradox of thrift.” People respond to the situation by being thrifty, doing what is good for them individually. But the outcome for society as a whole is bad. Under these circumstances, there is a need for collective action—that is, government action.

This collective action—this government action—will be most effective when it takes the form of deficit spending. And this is exactly what is meant when people talk about a “stimulus package.” By engaging in deficit spending the government is increasing demand more by its spending than it is reducing demand through taxes. The difference is made up by borrowing, and the “stimulus” is greatest when the borrowed money would not have been spent—and it would not have been spent precisely because the private firms and individuals who have the money (the money the government is borrowing) also have poor expectations about the future.

Not every economic downturn gets worse and worse. There can be a process of self-correction. But when a serious downturn develops—as is the case right now—self-correction is not going to solve our problems. The collective action that we can take through government is essential to avoid economic disaster.

Arthur MacEwan is professor emeritus of economics at the University of Massachusetts Boston and a Dollars & Sense Associate.

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