Economic Cycles as a Form of Spiritual "Payback"

Governments strive to keep their economies as healthy as possible, usually paying special attention to maintaining the fullest level of employment possible. But full employment has its own costs:

- Government stimulus programs result in higher taxes, putting a drag on economic activity
- lack of austerity reduces the incentive to maintain high standards for return on invested capital
- decreased appetite risk necessary for new ventures, since maintaining the status quo is adequate; result is that fewer new ventures are created

Deep recessions can creates a groundswell of sharp, tough decision-making among consumers that raises the bar for marketplace products, which has the effect of requiring lower prices and higher quality among businesses competing for a share of scarcer dollars. On the consumption side, having fewer dollars to spend tends to automatically enforce a higher consumption productivity, in which the same utility is generated from fewer expended dollars.

The hazard is pernicious: If the recovery from recession is too easy, consumers forget their tough, high return-on-investment habits and begin to make sloppier decisions. The right way to recover from recession is to have the recovery driven by the higher productivity of consumption and investment decisions among consumers and businesses, respectively. That is, as frugality is practiced more and more it becomes a habit and more ingrained. This frugality causes a national natural productivity boost, which then shows up in an expanding marketplace as consumers then find new surpluses at their disposal.

The converse also occurs: In boom times consumers feel that money flows to them easily. They get careless, and don't police their expenditures as much, or fail to shun higher-priced, less efficient services and products. Marginally inefficient activity fails to be curtailed during the boom, but then this leads to small decreases in the capital stock as resources are squandered and wasted and consumers fail to reward the good businesses and punish the bad businesses.

In the global scheme of things, a recession is a school lesson. It occurs because the nation forgot that it was supposed to be on good behavior. Once in the recession, the nation learns the good way, the right way, and these practices then lead to the recovery.

So the business cycle is payback: It is carrot and stick, rewarding you (economic expansion) for good habits (frugality) and punishing you (economic contraction) for bad habits (overspending or buying badly). It is a natural cycle, supplying invaluable feedback.

Stimulus interferes with this learning process. Supply enough stimulus, and the nation will forget how to invest in itself appropriately, and the lessons of frugality will be lost.

True Frugality/Prosperity Too Bitter for U.S. Leaders?

One of the essential elements of the business cycle is that it instructs market participants. When times are too good, immoderate behavior is rapidly rewarded, but soon after is then rapidly punished in the subsequent collapse. When times are bad, those who stored resources against bad times pick up bargains and benefit from their careful attention to economic reality.

The financial crisis of 2007 to 2009 is firmly rooted in overextension of credit to non-worthy borrowers. Clearly the lesson to be learned was "stop lending to poor credit risks; stop lending aggressively." As painful as a recession is, it really does reinforce the message that people must engage in economic behavior that is tied to reality. Unlike bubble behavior, in which people make investment decisions that are unsupported by economic fundamentals.

The collective decisions of consumers and businesses drive the economy. Each individual misallocation of resources hurts the long-term economy, even if in the short run it "feels good" or would seem to increase the velocity of money. When money is scarcer, the quality of these individual decisions rises. That is what generates recoveries.

If you have a recovery that is based on the millions of tiny gains that arise from good resource allocation decisions, then it is a sound one. If your recovery is based on a command-driven push to increase lending in order to restore some measurement of economic activity to a former level, then you are in danger of undermining your own long-term prosperity. Economic lessons in frugality are expensive; they hurt. We should not throw away the benefits of those hard-won lessons.

Are banks presently lending enough? It is a poor question. Better: Are banks meeting the existing demand for loans at prices that repay them for their risk? My sense is that commercial banks are lending appropriately, and if loans outstanding are dropping, it isn't their fault. Demand for loans is low and will stay low while consumers and businesses make prudent decisions based on the hard lessons they just learned.

This concept, that loan demand is dropping and is a good thing seems to be hard to grasp. Some people assume that loan levels are just set by the banks, and currently banks are being mean or trying to inhibit a recovery by failing to lend. This is echoed in the words selected by the interviewer in this video story at Tech Ticker. Mike Shedlock and Peter Atwater make the case that banks are reserving for current risks based on their customers' assessments of economic prospects, and that the building of non-loan assets is a reasonable use for their liquidity and has good historical precedent.

Conclusion: Profits are good now because of the steep yield curve, but consumers are laying a good foundation for a recovery through their credit decisions. There is a risk that this prudence could be short-circuited by governmental action, though my guess (95%) is that lobbying efforts for windfall taxes on banks, and other measures to force new risky lending, will not succeed.