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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.

 

17 comments
  1. Avatar
    John Daschbach

    Cullen, you persist with this view of macro economics which is based on not understanding the basics of mathematical modeling and scientific thinking. What is the economy? It isn’t balance sheets and income statements and it isn’t accounting. It is the real production and consumption of goods and services and GDP is the measure of real production integrated over a period of time.

    Ideal macro economics would never involve accounting or balance sheets or income statements. The real measure would be something close to how we treat energy (but include the mental efforts of humans as an important component of the aggregate measure of “economic energy”). Money, in macro economics, is just a proxy for this ideal measure, and it has many flaws.

    The language of economics is mathematics, not accounting. To say it’s accounting is wrong. A balance sheet is just the integral over a subset of flows (described by differential equations) in the economy and in fact because it is the integral from t=0 to t=now it has zero information on the macro economy. A balance sheet has zero information about the macro economy because time has been integrated out!

    A recession is officially described in the US as the finite difference first derivative of the production of the economy (d GDP/dt) being negative for two quarters. It really has nothing to do with a balance sheet or even money. We use money as the proxy for the real measure. It’s not assets and liabilities, it’s proxy measures of real production, I.e. People producing goods and services. The components are all proxies for real production: Consumption Expenditures, Business Investment, Net Exports, and Government Spending are just ways to estimate production based on the implicit assumption that these are dominated on the other side of consumption by the current production rate. The ideal real GDP is not balance sheets or income statements, it would be the integral over an entire population of the real production of each person minus the net consumption of real stored past productivity.

  2. Avatar
    blonderealist

    It seems that your objections to Cullen’s view are mostly about balance sheets. I’m not sure why, since he does not seem to give more weight to balance sheets than income statements in his macro view.

  3. Avatar
    Cullen Roche

    Sounds to me like you’re doing what neoclassical economists do – you’re trying to cancel out the importance of money in the financial system by applying a barter system focused on the “real world”. But the modern financial system is an accounting based representation of the way certain non-financial assets are reflected in the financial asset world. The finanical system is much more than just the non-financial asset world.

    Focusing on math tries to apply real variables to accounting constructs. The entire financial system exists on spreadsheets, not in mathematical realities. I can create these spreadsheets from nothing and this creation could have ZERO grounding in any mathematical or reality based construct.

    Math misleads a lot of economists into thinking that the accounting based financial system can be quantified and modeled in a predictable fashion. It’s what’s so wrong with much of modern economics….

  4. Avatar
    John Daschbach

    Clearly you don’t understand what science and the part of economics that tries to adhere to scientific logic is. Comments like “you’re trying to cancel out the importance of money in the financial system by applying a barter system focused on the “real world” make it clear that you don’t understand the huge difference between real macro economics and finance. What you think of as macro economics is not macro economics, it’s financial economics. It’s not macro economics, it is mesoscale economics. The real economy is not the financial world, rather the financial world is a distorted transformation (Jacobian) of the real economy onto the financial space.

    The financial system is coupled to the real economic system. But the real economic system is absolutely only real production and real consumption and nothing else. As I tried to make clear, macro economics often uses financial observables as proxy measures for the real economy.

    If you understand that the accounting based financial system is used as a proxy for the real economy then you wouldn’t say that “Math misleads ..” In reality it’s the financial system that misleads.

  5. Avatar
    Cullen Roche

    This is precisely the mistake. You’re proving my point without knowing it. The idea that the financial system is just a proxy for the “real economy” understates the importance of the financial system. You are acting as though there is something “fake” about the financial system. Yes, it’s true that the financial system is created from our imaginations, but that doesn’t mean it isn’t “real”. That’s like saying that my feelings about people I love aren’t “real” just because they aren’t expressed in some physical form. You can’t model my love for other people. But who cares. That doesn’t make my feelings less “real”. It just makes it really hard to model. Same basic idea applies to the financial system.

    You neglect the financial system because you don’t think it’s “real”. This is precisely how most economists approach economics in a weak attempt to make it more scientific. Economics isn’t a hard science. There is a sophisticated behavioral side to it that will never allow it to resemble a hard science. But here you are trying to apply the hard sciences to it….It will never work completely.

  6. Avatar
    Suvy

    This is a really well written post. I like this post a lot. It’s spot on IMO. We just have to remember that every balance sheet entry represents some sort of claim on real resources.

  7. Avatar
    Blue Aurora

    Hello Cullen Roche! It has been a while. I thought this post was lucid and succinct, and a joy to read. However…I have two questions for you:

    1.) Have you read Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and its Global Implications or The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, both by Richard C. Koo? If you have read either one of them, what are your views on his arguments?

    2.) I still need to get back to you on correspondence, but…do you still recall the peer-reviewed scholarly articles about the mathematical expositions in The General Theory of Employment, Interest, and Money by John Maynard Keynes? They were published in History of Political Economy and the History of Economics Review, IIRC.

  8. Avatar
    Cullen Roche

    Hi BA,

    Yes, I read Koo’s book in 2008 I think. It’s excellent.

    I can’t say that I recall reading the Keynes pieces. I’ve been swamped with work in the last few months so I don’t have as much time for reading as I wish. I’ll try to have a look at some point….

    Thanks for the kind comments on the post.

  9. Avatar
    Blue Aurora

    WRT Richard Koo…I see. Do you plan on reading his earlier book, Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and its Global Implications, at some point?
    As for the papers on the mathematics of The General Theory…well, do you still have my e-mail address, at least?

  10. Avatar
    Matt

    Exactly. Because many economists treated the ‘financial economy’ as ‘just a proxy’ for the ‘real economy’, even leaving out money and banks from their macro models, they weren’t able to see the big recession coming.

    Both systems are real and need to be taken into account at the same time. The ‘real’ economy consisting of transactions of goods and services and the ‘financial’ economy of stocks and flows of money. Both systems are highly interconnected and in both systems human behavior (both individual and group) plays an essential role.

  11. Avatar
    pliu412

    Another issue is that economic variables/parameters used in math economic models are not consistent with the accounting defined terms and the terms relationships in accounting constructs. For example,
    we often see this formula: fed government deficit = T – G

    Accounting is already chosen as Data Definition Language of economics and finance in SNA2008, NIPA, and Z1. The official economic and finance data are collected according to these standardized definitions.

  12. Avatar
    John Carney

    I’m not sure I understand what you mean when you say “the financial world is a distorted transformation (Jacobian) of the real economy onto the financial space.”

    The financial economy, that is the balance sheets and income statements, has very important effects on the goods and services economy. For instance, people aren’t buying houses because of the state of their balance sheets (too much debt) and income statements (too little income).

    https://libertystreeteconomics.newyorkfed.org/2014/09/why-arent-more-renters-becoming-homeowners.html#.VBCtkxBdVii

    Given this dynamic, it doesn’t make sense to me to separate the financial economy from the “real” economy.

  13. Avatar
    John Daschbach

    I don’t neglect the financial system at all. The financial system has large feedbacks into the real economy.

    What I think that you, and many others don’t understand, is what underlies creating an abstract model of any process. In any abstraction, the goal is to reduce the number of independent variables. In the linear world this is finding the orthogonal basis vectors which span the entire range. In the non-linear world this is the orthogonal basis functions which span the range.

    But to anyone who understands what an abstract model is, finance (and therefor money) are never an independent variable in any representation which spans the range of observables. We know that money and finance is not an independent basis function because we can construct systems based on other models for real economic transference (e.g. barter to communism). Thus it is a requirement for macro economics to treat money not as a basis function but as a function which is highly coupled the economy and which also therefor provides reasonable proxy measures for the real economy.

  14. Avatar
    Willy1964

    A business cycle is a credit cycle. When credit growth is accelerating the there’s economic growth and when credit is contracting or de-celerating then we’re in a recession. Sound simple to me.

  15. Avatar
    Cullen Roche

    You didn’t say anything that I haven’t already said. All you did was use some math terminology that makes things way more complex than they need to be.

    The bottom line is, you can’t model the economy or human behavior using math so math will only get you so far in the world of economics. It has its limits in the limit (haha, get it?).

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