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From Recession to Depression: On the Theory of Economic Crisis

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NEW YORK – March 1, 2019

Among the numerous theoretical issues of the cyclical development of the world economic system, the problem of economic crises occupies a special place. This is due not only to the fact that the crisis is an element of a cyclical mechanism. The overwhelming majority of economists believe that a crisis is a constitutive phase of the economic cycle. It is in the process of the crisis that the directions and principles of the future dynamics of the economic system are largely formed.

However, as a crisis developed, when the political component in economic processes began to play an increasingly large role it turned out that neo-economic theory does not provide answers to many burning questions.  It turned out that in conditions of a severe crisis, purely economic structures and models do not provide an explanation for the processes taking place. But the methodological schemes of political economy turned out to be much more effective.

Unfortunately now the methodology of political economy is practically prohibited by mainstream economics doctrine. And since this ban was introduced quite a long time ago, an entire generation of people who think only in categories of economics doctrine has grown up. That is why modern economic theory cannot even adequately describe what is happening, let alone explain the reasons and ways out of the crisis. We are trying to describe the situation in the pure format of political economy, without the ideological restrictions of economics.

Consider first the patriarchal agricultural economy. Aside from some major cataclysm and seasonal variations, yearly growth in such an economy is approximately constant, which may be illustrated as follows:

Х(t) = (1 + А)t * Х0

where Х(t) is a measure of the general size of the economy (e.g. GDP) and  А is constant yearly economic growth. Normally,  А lies between 2% and 3%, that is,  А = 0.02-0.03. Thus, economic growth is exponential, which means that in time it will become fast but in early stages is approximately slow-rising linearly (when non-linearity becomes significant, other factors, not discussed here, will manifest, so that the formula of economic growth will become more complicated, and the growth itself will become much slower).

Massive lending is widely considered to stimulate economic development and human well-being, and the World Bank’s activities are based on exactly this premise (it regularly publishes on this topic). Reality, however, is more complicated. Including lending in the model, we can describe the resulting economic growth curve as follows:

Х(t) = Х0((1 + А)t + ∫К(t)dt)

where К(t) represents the rate of economic change due to lending. In any real economic system К(t) varies depending on the relation of outstanding and returned loans. Initially it is, obviously, positive, but with time the situation will change. The main emerging feature is that the economy becomes cyclical (as extensively described by the Austrian School scholars): As we can see in Fig. 1, the accelerated growth is followed by a negative growth rate (loans must be repaid). At this moment the finances in the system get redistributed, and accumulated loans decrease.

Thus, after initial surge the system attains more or less sustained (but not constant) growth, with the growth rate lower than that of the “natural” system: Added returned loans, including interest, with time necessarily exceed added outstanding loans, and this loan debt pushes the rate of growth down. If we don't count the loan debt as an asset, the integral of К(t) will be negative.

As positive values of К(t) are replaced by negative values (the economic system consistently gives more than it receives), the long-range average growth becomes constant, whereas in the middle-range perspective the system is cyclical, with accelerated growth phases alternating with more pronounced drops. Thus, the overall size of the economy with lending is smaller than of the economy without lending.

“The economy without lending grows faster than the economy with lending only in the absence of innovation (that's why our first example was the patriarchal system). As soon as we include the scientific and technological progress, single producers will need some mechanisms to reduce their risks, and lending is one such mechanism. Thus, it is an oversimplification to say that an economy without lending is always more effective than an economy with lending. Exactly this observation makes the position of the World Bank complicated: The necessity to finance innovation makes a formally untenable position less so.”

A system with lending must include two important parameters. Firstly, average loan repayment time  T, which determines average cycle length; and secondly, average loan size M, which shows the deviation of the cycle from long-range trend. Some examples on the variation of these parameters are shown in Figs. 1-3 (red line - “normal” growth without lending, blue – growth with lending, yellow – growth rate without lending, grey – growth rate with lending. Growth rates are shown multiplied by 10).

From Recession to Depression: On the Theory of Economic Crisis

Fig. 1. М = 0,2Х0, Т = 1

From Recession to Depression: On the Theory of Economic Crisis

Fig. 2. М = 0,5Х0, Т = 2

From Recession to Depression: On the Theory of Economic Crisis

Fig. 3. М = 0,4Х0, Т = 4

An important observation here is an effect which may appear in a system with lending, and only in such a system: If the size of loans exceeds some critical value, the growth rate after initial surge may become negative for a long time period. Such a situation leads to major problems for a real economy, thus contradicting the idea of sustaining growth by more lending. A good example is Fig. 3, where Х0 = 1, А = 0,03, Т = 4, М = 0,4Х0. These problems are described in post-2008 crisis articles. For such parameter values our model must be elaborated and compounded, because in reality endless negative growth is impossible. The first step would be to take into account a drop in lending at the beginning of recession (a relatively long decline within the cycle). However, even after recession, the growth rate will be slower than in the system without lending: The economy will be weakened by financial leaching.

Another important difference between systems with and without lending is that the first includes feedback: К(t) depends on the growth rate. This dependence is pretty straightforward, as the added loan size is also a cyclic function with phase lag in relation to growth rate. This model describes, in first approximation, the USA economy from 1947 to 1971, when flexible financial support of producers allowed to avoid major crises.

The next necessary step in developing the model is to include state governance with political goals (where we understand “state” in a very wide sense, as not only the government, but the ruling elite in general). Let us assume that the purpose of the state is to avoid a critical drop in growth rate by raising the size of accumulated loans. This means that when debt return exceeds new loans (or, К(T) becomes negative), the state will artificially raise the new loans by non-economic methods, e.g. by money printing (emission). In terms of our model, when the production curve reaches its maximum and starts to drop, even remaining above zero, the available loan mass (parameter М) is artificially raised (cf. Fig.3). Thus we jump to another curve, the local maximum of which is to the right of the old one – i.e. later in time.

We can describe such a model by the following formula:

Х = Х0((1 + А)t + ∫(К(t) + К1(t))dt)

where К1(t) represents the growth rate due to a lending raise. In this model К1(t) = 0 during the economic growth phase, then it raises significantly, after which its curve is similar to К(t): It cycles with an average a little less than zero.

The key question here is, why do we need two parameters, К and К1, which seem to be more or less the same? The  К parameter describes a “natural” economic system, and its average value is negative for the long time interval, because the sum of returned loans will exceed the sum of outstanding loans (by the value of interest rate).  К1, on the other hand, reverses this balance: For some time after its appearance credit balance will be on the outstanding loans side.

But why not just describe a system with initially greater loans mass? Look at Figs. 1 to 3: If the accumulated value of  М (loan size) exceeds the economy size by some critical figure, the time interval with negative growth will be too long, and the economic system will start to disintegrate. In our case, however, this happens in a stepped fashion: After the system with the first surge due to introduction of К1 starts to drop, a  К2 parameter will be introduced, and so on and so forth. On each step the difference between М and the economy size is not too great, and the economic system growth is positive.

This model allows to sustain significant economic growth for a much longer period of time, but not indefinitely, and the consequences are dire: The greater lending growth, the deeper will be the fall after (Figs. 4 and 5):

From Recession to Depression: On the Theory of Economic Crisis

Fig. 4. М = 0,4Х0, Т = 4, М1 = 0,8Х0

From Recession to Depression: On the Theory of Economic Crisis

Fig. 5. М = 0,4Х0, Т = 4, М1 = 0,8Х0, М2 = 1,4Х0

Thus, state governance, by stimulating economic growth with loose monetary policy, may lead after a long period of economic growth not just to a “normal” recession, but to a global depression, when the system not only cannot sustain growth but also does not react to any “safe” (by order of magnitude) control signals.

Let us get back to the current state of the world economy. Can the 2008 crisis (and follow-up problems caused by governments striving to maintain GDP and living standards of their citizens in short term, or till the next elections) be described by the model proposed here? To answer this question, more research is needed, but the US private debt curve (Fig. 6) gives some reasons to say “yes.”  Here we can see the US economy figures in billions USD, 1981 to 2014 (blue line – real GDP, orange line – accumulated private debt):

From Recession to Depression: On the Theory of Economic Crisis

 Fig. 6

Compare with the results calculated for our model with  А = 0,03, М = 0,4 – 1,2 (with a continuous rise in lending), Т = 1,3 (Fig. 7):

From Recession to Depression: On the Theory of Economic Crisis

Fig. 7

Obviously, we derived these parameter values not from the stepped model illustrated in Fig. 4-5, but for a continuous rise of lending stimulation under the beginning recession conditions. Note that these values are way too high for lending stimulation measures to be sufficient for providing economic growth, i.e. for monetary policy to be effective as means of economic stimulation.

Let us conclude with the following. Note that with a significant growth of lending mass in the economy, the state changes its methods of statistical analysis, thus creating the illusion of real economic growth. Existing estimations of current GDP by methods used previously show, for example, that the US economy has in fact for some time had negative growth. An additional corroboration is the fact that even the nominal growth rate of the US GDP from 1981 to 2008 are lower than their combined government and private debt (Fig. 8):

From Recession to Depression: On the Theory of Economic Crisis

Fig. 8

The proposed model allows us to explain the fact that the US’s economy fails to achieve more or less sustained growth: Its current condition is not a recession within a semi-stable cyclic process but a major depression caused by the superposition of multiple recessions from several cycles with different levels of lending mass. Another explanation of this depression could be negative economic growth (economic shrinking) caused by stable lending growth, but with impossibly high lending mass. In order to return to real growth the economy must be cleansed both of excessive lending mass (accrued outstanding debt) and of fictitious GDP created by monetary stimulation.

Author: USA Really