The Daily Update - 'Why Do Economic Expansions End?' Part II

Part II: Why Do Economic Expansions End? Imbalances and Recessions

Contrary to neoclassical theory in which economies supposedly settle into stable equilibriums, economic expansions always engender imbalances in either the real economy or the financial sector. Their origins often are rooted in the destabilising tendencies of business investment and the undisciplined and profligate nature of most governments. Businesses misjudge demand, overproduce and end up with too much inventory of unsold products, as now seems to be the case with European automakers and Chinese steel producers. Likewise, developers invariably build too many office buildings and resorts, while manufacturers invariably build too much capacity, as is the case in Asia today. Although technology and globalisation have mitigated those business blunders, the chain of events from boom to bust remains much the same – namely, it runs through the credit channel and eventually unsettles the financial system.

Financial imbalances, on the other hand, tend to be less transparent and more catastrophic than those in the real economy because they impair bank balance sheets and in turn undermine the availability of credit, which is the lifeblood of most economic activity. Although we are aware of the numerous pockets of unsustainable debt that smoulders on bank and government balance sheets – from student debt and leveraged bank loans in the US to private wealth products and corporate debt in China to over-leveraged real estate almost everywhere -- it often is difficult to anticipate when those smouldering debt piles will burst into flames. As long as lenders roll over debt obligations, defaults are suppressed. When circumstances change, however, and borrowers no longer can pay, banks tighten lending standards, and capital markets freeze up. Without short-term financing, economic activity withers.

The most often cited change in circumstances is when central banks belatedly tighten monetary conditions. Indeed, the perception that central banks cause recessions by raising interest rates is pervasive, even among professional economists and investors who should know better. A shrewder reading of history is that central banks set the stage for recessions by leaving monetary conditions too loose for too long. The plentiful flow of easy money during expansions breeds excesses in borrowing, leverage, government largesse and even fraud that come home to roost at the end of the business cycle.

Part III, Unwinding Quantitative Easing, will be published tomorrow.

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