Why We Must Have A Recession
BROCKWAY, GEORGE P.
The Dismal Science WHY WE MUST HAVE A RECESSION By George ? Brockway Probably at least once in every one of the 18 years I've been writing this column, I have made fun of an obiter dictum of...
...I have been belaboring the obvious because it is essential for understanding one of the crucial problems of our time—the relation of the interest rate to the price level in a modern economy...
...manufacturing precedes delivery to customers...
...they are analytical problems...
...There is absolutely no way of telling from the statistics or the graphs themselves which "really" comes first, the interest rate or the price level...
...In other words, while the hallowed law of supply and demand was plausible enough in the isolated market towns of Adam Smith's day, it no longer is absolute —except in the narrow confines of Wall Street, where the supply of investment grade securities is strictly limited...
...Even money that you or the company may have on hand has an opportunity cost—that is, what you might have made if you had invested it in some other way...
...But the basic price of their product is set by the Federal Reserve Board...
...To be sure, the Federal Reserve worries publicly about the supply of labor, and that is certainly at least biologically limited, although relaxed immigration laws could provide short-run solutions and expanded education could extend the long run...
...Special projects may be planned all at once...
...The interest rate has an effect on prices, because it is a cost, and costs have to be covered by prices...
...Instead, there is much talk of pre-emptive strikes, and of the importance of being ahead of the curve...
...the sales department does market research...
...We know from our analysis that the interest rate affects prices, but there is no way for prices to affect the interest rate...
...In short, borrowing comes first and its price depends on the interest rate...
...Interest rates have to be set before the financing of any good or service is agreed to...
...If you (as an individual or a corporation) plan to start a new business, or to expand an old one, or to merely keep an old one going, the first thing you have to do is look for financing...
...In this, the question is like that of the three-way colonial trade (guns and calico for slaves, slaves for cotton and rum...
...delivery requires prices, which must be set to cover all the previous costs, plus, it is hoped, a profit...
...The hawks demand a further interest rate increase...
...A chicken makes an egg, and the egg makes a chicken, and that chicken makes an egg, and so on...
...It is possible to assemble the statistics and plot curves showing the fluctuations of the interest rate and the price level...
...To be sure, different companies follow different routines to achieve the same result...
...If you then start with the other one, their roles will be reversed, and the lag will be different...
...Prices may affect the sensibilities of the Federal Reserve's governors, and they do in fact set the interest rate...
...Let's heed Deep Throat's advice and follow the money...
...If we keep it up, we must have a recession...
...The scene is like Zeno's paradox of Achilles and the tortoise, except that the Achilles of the interest rate can't catch up with the tortoise of inflation, because Achilles is carrying the tortoise and even pushing it out ahead of him...
...These are not statistical problems...
...Following the money, we see that when the interest rate goes up so does the price level...
...Leaving aside the Reserve's sensibilities, prices do not affect the interest rate, because the interest rate is set before prices are...
...Raising the interest rate can only slow down inflation if the Reserve keeps raising it until the whole economy is put into reverse—until, that is, millions of men and women lose their jobs, hundreds of thousands of businesses go bankrupt, and public works languish...
...The business press frequently writes that in certain situations (usually good news, like increasing employment and more prosperous businesses) the Reserve "will have to raise rates," but there is no natural law or legal requirement that forces it to take the specified action...
...I think it is still good for a laugh, although of course it is undeniably true, and so is my variant: When many people raise prices, inflation results...
...All that exists at the beginning is a price range, a schedule of standard specifications, and a menu of desired special features...
...You can get money in lots of ways...
...In any case, the country is full of inflation hawks—and that includes many governors of the Federal Reserve Board —who are constantly on the lookout for the most obscure forecast of the inflation they fear...
...For demand-pull inflation to work, supply has to be rigidly limited and in a modern economy there is practically nothing that cannot be readily and indefinitely replicated within a reasonable span of time...
...I'll go a step further: It is only when many people raise prices that we (including the Federal Reserve Board) know we have inflation...
...The price level inches up, and actual inflation shows itself...
...What happens in these circumstances...
...A strong argument can be made that in a modern economy inflation, when it occurs, is practically always cost-push...
...And I'll take another small step for man but a momentous step for understanding the economy: Except in time of war or disaster, we have inflation only when the central bank (the Federal Reserve Board) brings it about...
...After all, the name of our system is finance capitalism...
...No precise formula guides the process...
...We're on our way...
...You can sell shares or unneeded assets to a more venturesome fund or to a friend or on an exchange...
...In fact, we've seen the ending nine times since World War II...
...cotton and rum for guns and calico...
...If the Reserve does raise rates, it is because of the governors' own free will, guided by their own economic theory, which in this case happens to be fallacious...
...Well, we've seen how the story ends...
...but the car is not built unless the finance department can be reasonably sure of necessary monetary support at a feasible interest rate...
...financing precedes manufacturing...
...Thus the price level, an aggregation of all the prices in the economy, is systematically subsequent to the interest rate...
...As Iago said, put money in thy purse...
...Many arrange a line of credit with a bank to prepare for the needs of a year or a season or a project...
...Yet the experience of the last few years should have taught us that neither the wisest statesmen nor the most erudite economists have the faintest idea where or whether there actually is a natural rate of unemployment (that most barbarous notion), beyond which inflation must rage uncontrolled...
...Why do we have to do it again...
...The Dismal Science WHY WE MUST HAVE A RECESSION By George ? Brockway Probably at least once in every one of the 18 years I've been writing this column, I have made fun of an obiter dictum of President Calvin Coolidge: "When many people are out of work, unemployment results...
...Indeed, it is widely said that the Reserve must act now...
...Their overheads merely account for the differences between the rates of your friendly neighborhood banker and those of the snobbish bank in the next town...
...Banks and other lenders have to make ends meet, too...
...Depending on where you start, the peaks and valleys of one will necessarily follow those of the other with, as they say, a lag...
...Even international cartels controlling natural resources, such as the Organization of Petroleum Exporting Countries, are of bounded effectiveness because of the development of substitutes and the threat of military reprisal...
...In general, though, even a small interest hike will result in a noticeable hike in the price level...
...The engineering and design departments see what they can do...
...Nevertheless, this is not a chicken-and-egg question...
...However all this may be, the fact remains that the interest rate must be agreed to by each enterprise before the enterprise is able to make a responsible attempt at setting its own prices...
...Some entrepreneurs will hold their prices down and be satisfied with a lower profit...
...Well, I'll take that, or a little of it, back...
...That is not to say that finance is more important than (or even as important as) engineering or design or advertising or sales...
...The dictum stands: Interest rates affect prices, but the Reserve, not prices, affects interest rates...
...This is the way capitalist business runs, and there is no better way to run it...
...It is simply to say that finance is primary...
...When former Federal Reserve Chairman Paul A. Volcker was asked if his policies might lead to recession, he replied, "Yes, and the sooner the better...
...so their prices (the interest rates) have to be high enough to cover their labor, capital and rent costs...
...It does not make much difference how you finance your enterprise, but you have to do it, and it will cost you...
...You can borrow it from a bank or from a venture fund...
...He showed how it was done...
...Please note that it does not matter whether inflation is thought to be demand-pull or cost-push...
...Some will manage to cut other costs— technological, administrative, sales, advertising, and so on...
...An automobile company may glimpse a chance for a new sports utility maxivan...
...Recently they raised the rate, and they threaten to raise it further, despite their admission that there is no significant evidence of coming inflation...
...You can use money you have on hand or your company has on hand...
...The causation goes only from interest rate to prices, not vice versa...
Vol. 82 • August 1999 • No. 10
