Feb 11 2009

Will the economy self-correct?

Does the Economy Self-Correct? – Welker’s Wikinomics Page
The debate in Washington over Obama’s fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly $1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington’s stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

  1. Falling demand in an economy means less output by firms, forcing them to lay off workers.
  2. As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).
  3. High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.
  4. Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.
  5. Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.
  6. The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

GM Slashing 10,000 White-Collar Jobs, Cutting Pay – washingtonpost.com

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation’s resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM’s wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

3 responses so far

3 Responses to “Will the economy self-correct?”

  1. David xuon 12 Feb 2009 at 10:20 am

    So… I just wrote a whole blurb and you're (damned) prized website just erased it all because i didn't put my email down. #@$@$!!!! haha.

    As much as I think supply-side economics will work, the government has to do something to assure the people so they will keep spending and not worsen the recession.

    All the same, you see executives and everyone taking a pay cut and I can't help but think that this recession is really pulling people together. At Brown, I read today in the newspaper that there are going to be spending cuts, but more surprisingly, our president, Ruth Simmons who makes around 700K, has proposed to reduce her salary and it was finally accepted by the Corporation.

    Her act of altruism really inspires me that in this crisis we may find a silver lining. It's kinda like the Allstate commercial (i dunno if you get those in europe), it's back to the basics. We gotta learn how to enjoy the simple things instead of living lavishly. This recession is global and only as a global community can we come together and overcome it.

    Peachy I know, but it's the truth! How's xbox? I want to get one… the price hasn't dropped much surprisingly. I guess its cuz they just produce less to keep the costs up. It's retarded. lol.

  2. Jason Welkeron 12 Feb 2009 at 10:41 pm

    Hey David!

    Great example of downward wage flexibility, the president of Brown taking a voluntary pay cut. Man, imagine if the executives at America's financial industry had such ethics! Speaking of Ivy League, I just heard that Harvard has lost $8 billion from its endowment in the last 8 months… how will this financial mess affect America's top learning institutions?!

    Thanks for the comment David, good to get some insight from one of my favorite former Econ students!

    Mr. Welker

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    Will the economy self-correct? | Economics in Plain English