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Bradley Hilltopics

Spring 2009 • Volume 15, Issue 2  

Notebook

 

Riding the recession wave

illustration of a surfer on top of wave with large shark lurking underneath

Do you remember when you first figured out the “miracle” of compound interest, how $1,000 lent at 10 percent interest for say, 36 years, will turn into $30,000? On the other hand, it may have occurred to you that it’s crazy to pay $29,000 to borrow a measly $1,000, even though the interest is paid out over many years and mostly at the end. Well, suppose that crazy guy takes your money (and a lot more), invents a product, figures out how to get it produced, and who to sell it to. He does so well that he can pay the interest and still have money left over. He looks like a genius, and you do alright too. Usually, of course, both parties actually deal with a bank or one of the various Wall Street institutions we collectively call the financial system. You have participated in the most important thing financial markets do: channel funds from savers to those businesses best able to invest them.

That’s the way it’s supposed to be. As it is, with many people all over the world feeling burned or frightened, and the financial institutions themselves frequently in disarray, it hardly needs saying that the global financial system is in crisis, and many countries are in recession. The factors behind the crisis are considerably more complicated than just Googling a compound interest calculator, or even understanding and valuing a smorgasbord of financial assets, bonds, equities, mortgages, and the various packages of these. A major sea change in financial markets has been the extent to which the value of financial assets depends on how many other people are willing to buy those assets, now and in the future. In the language of economics, asset prices are subject to network effects. When people believe other people will buy an asset, its price goes up; when they don’t, its price falls, regardless.

Network effects explain why the stock prices fell so dramatically over the last year, not only for firms with poor performance, but for those with excellent past performance and reasonable prospects for the future. Network effects also increase the riskiness of financial assets. When the players in the financial markets, both sellers and buyers, don’t understand the risks of the assets, a financial crisis is just waiting for a trigger. For the U.S., the trigger was the bursting of the housing bubble, although it should be noted that countries without a housing bubble did not escape. Likewise, the crisis and subsequent recession have hit “saver” countries like Germany and China just as hard as “debtor” countries like the United States. Apportioning the blame for allowing/encouraging/not prohibiting buyers and sellers from dealing with financial assets whose risk they didn’t understand will be a task for economists for many years, just as understanding the Great Depression was for most of the 20th century.

The more immediate problem is the painful but obvious effects of recession: businesses shut their doors, and people are out of work. Fortunately, the macroeconomists in the econ department, Dr. Raymond Wojcikewych and Dr. Joshua Lewer, forecast the economy out of recession and observing positive economic growth sometime in the second half of 2009. The government has passed a sizeable fiscal stimulus package which will increase household income either directly or indirectly. How the fiscal stimulus affects the economy is a question of how we use the increased income. We might use the money to save or retire debt, say pay down a credit card; that might be responsible household decision-making, but it would do nothing to provide customers for business — the thing they most need and upon which the recovery depends. For any stimulus package to bring us up and out of the recession, households need to buy something, anything, a Disneyland vacation or a new refrigerator. And remember that as bad as a recession is, the great risk is that problems in the financial markets persist, causing a Japanese-type “lost decade” with stagnant economic growth. The probability of that outcome is not insignificant.

Macroeconomics has two fundamental principles: (1) The prosperity of each individual cannot be divorced from the prosperity of the larger world; and, (2) what is good for an individual may be detrimental for society at large, and conversely. Sobering principles in the best of times; heartbreaking now.

 

Dr. Jannett HighfillDr. Jannett Highfill is a professor of economics and editor of the Global Economy Journal. A more extended treatment of the crisis can be found in “The Economic Crisis as of December 2008: The Global Economy Journal Weighs In,” Global Economy Journal, 8(4), article 4: http://www.bepress.com/gej/vol8/iss4/4.