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Pragmatic Capitalism

Practical Views on Money, Finance & Life

What Causes Recessions?

I am still working my way through the Q&A from the other week and I really wanted to highlight this question because it’s a good one:

“Noah Smith is always saying that no one knows what causes the business cycle, and in particular recessions. How would you respond to this?”

Economists don’t tend to see the economy the same way I do.  That is, at its macro level, the economy is really just made up of a bunch of balance sheets and income statements.  As I like to say, the language of economics is accounting.  If you don’t understand accounting then you are probably going to have a hard time understanding macroeconomics.

Based on this understanding the economy is just a bunch of balance sheets and income statements so recessions must occur due to shocks in these income statements and balance sheets.  If we could construct an economy where balance sheets and income statements grew at perfectly stable and steady rates then we wouldn’t have recessions.  After all, recessions are just 2 quarters of negative GDP.  So recessions are due to balance sheet and income statement disruptions.  But what causes these disruptions?

The short answer is that lots of things cause recessions.  You can have demand side shocks like a credit crunch, higher interest rates, falling real wages, etc.  You can have supply side shocks like spiking oil prices or other production shocks.  It really depends on the specific environment and the various macro drivers that lead to balance sheet and income statement shocks.  Interpreting each business cycle requires some degree of unique understanding of how the economy is evolving within each cycle.

In its simplest form the cause of recession is always derived from balance sheet and income statement shocks.  Those shocks can occur in many different ways and so an understanding of potential risks during the cycle should involve an understanding of the economy at its macro levels.

 

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