Monday, October 20, 2008

The virtue of recessions

Last week I was chatting online with a friend of mine who works in finance who opined that "we need a deep recession to fix things." To many people this might sound strange or abhorrent, but it's actually quite a good point.

Recessions are a good sign that too much investment has been made in bad parts of the economy and need to be reallocated to more efficient uses. For example, the recession that occurred in 2001 was in large part a product of the hangover from too much money going to dot-coms that had nonviable business models. The current recession -- and yes, at this point I am going to go ahead and call it that -- is a product of a housing boom founded on easy credit. Recessions are a time for the economy to cleanse itself of these impurities and lay the foundations for future growth by shifting resources to more productive areas.

In fact, the biggest danger to future growth is that politicians in a bid to gain office may put in place programs -- in the name of saving jobs -- that retard this process of retooling and reallocating resources. While this may seem harsh, some jobs just aren't meant to be. We simply don't need as many realtors at the moment. If U.S.-based automakers go belly-up it's a sign that Toyota and other manufacturers should be doing the job instead while Americans should shift to more productive endeavors.

Remember, we are only as rich as what we produce. You can only consume what you make. You can't be paid $100 to produce $75 worth of stuff or your company will go bankrupt. The trick to rising prosperity is for every person to focus on that job that they can do best and generates the most economic activity.

Consider the case of self-checkout machines at the grocery store. For the same of simplicity, let's assume that a store has 8 checkout lines. Each one is manned by one cashier that is paid $8/hour. Now let's imagine that 4 of the checkout lines are replaced by machines. That will save the company a fair bit of money -- assuming the store is open 12 hours a day, 7 days per week, that is around $140,000 a year that the company is able to save without sacrificing anything in the way of sales.

Doing the same with less is more efficient. That efficiency allows the company a choice of what to do with the extra money, such as cutting prices to attract yet more consumers or paying its existing workers more. That extra money will find its way back into the economy, stimulating the demand for more goods which in turn will prompt more industries to hire to meet the added need for its products -- perhaps hiring the four people that were laid off when the machines were installed. Despite the wrenching pain of the job change in the end society is better off.

Indeed, to do otherwise is simply to make ourselves poorer. As Robert Samuleson says in his column today:
We go through cycles of self-delusion, sometimes too giddy and sometimes too glum. The only consolation is that the genesis of the next recovery usually lies in the ruins of the last recession.

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