The Bubble Bursts

Will the Recession Be So Severe That it Will Count As the ‘Millennium Depression’?
Listener 2 November, 2002.

Keywords: Globalisation & Trade; Growth & Innovation; Macroeconomics & Money;

There was increasing pessimism about the state of the world economy among the international economic commentators I admire. Those who are paid to talk up the financial markets continue to predict optimistically – so far, four of the last zero economic upturns.

As the serious commentators see it, the issue is how long the recession will continue. By a recession they mean the world economy will grow slower than its capacity, with rising unemployment, falling investment, and business bankruptcies. To the long time pessimism about Japan’s prospects, and increasing nervousness about Latin America which seems to be being dragged down by Argentina, they now see Europe as stagnant. But the greatest worry remains the US economy, whose fundamentals seem deeply problematic.

In the late 1990s, the US economy experienced exceptionally strong economic growth accompanied by what the London Economist has described as its ‘greatest financial bubble’. The bubble has not so much burst, as it is steadily deflating. Even so, sober commentators – but not all the hired financial commentators – considered US share prices still excessively overvalued.

The approach of the great Austrian economist, Joseph Schumpeter helps us understand the boom and bubble. He investigated those business cycles which were stimulated by a major technological innovation. It might be railways or cars, but most recently it has been the revolution in information and communications technology. Schumpeter saw such innovations making genuine contributions to economic output and individual welfare in the long run, but the process through which this occurs causes a speculative boom in the short run and much hardship in the medium run.

Initially the innovation generates new investment and useful products. But nobody is quite sure what their impact will be, and some make wrong guesses. Where they underestimate innovative potential then it arrives late (or the underestimater’s firm goes to the wall). Others try to introduce new products and services for which there is no significant commercial demand. (The boom is as an example.) Implementing the entrepreneurial ambitions requires borrowing, and investors rush in with their savings. Because everyone is doing it, the financial system expands credit, as it lends to individual investors and businesses. So the technological expansion is associated with a speculative boom – a financial bubble.

Where an investment is a success, the borrowing pays for itself. But success breeds enthusiasms for less viable undertakings, and soon the business sector has myriads of unsound businesses which are being sustained by credit. Lacking cash flow, they eventually collapse. When enough do, the bubble bursts or deflates. Into recession – or worse – goes the economy. Investors lose their savings, and some of them end up with negative equity. Some financial institutions fall over too. And there is usually some collateral damage among sound firms which have unfortunately got exposed to the unsound ones. Schumpeter called this process ‘creative destruction’ since the elimination of the deficient businesses leaves room for the firms with useful technology to grow, albeit after the recession.

Everyone – the gullible aside – seems to be discounting the role of monetary policy. If it could not restrain the bubble it wont be able reflate the burst. However the standard Keynesian remedies have to be applied with care in a Schumpeterian bust . If the additional government spending simply props up the balance sheets of the non-viable firms, it prolongs the recession, since that does not purge the unsoundness.(Muldoon should have taken note.) That is why the Japanese economy was stagnant in the 1990s. The Bush tax cuts of last year also seem to have been spent on failures. (One of their beneficiaries was the bankrupt Enron.) The private sector debt is simply transferred to the government, and the necessary creative destruction does not happen.

The Japanese experience also suggests that any public investment needs to go to improving the productive capacity of the economy. If it does not, the debt servicing goes up, but there is no additional tax revenue to pay for it in the long run. Both the US and the Japanese governments are building up large public debts, with no public assets to match them and, in the Japanese case, without addressing the defective businesses. While any economy always has some, as long as the proportion is high, the post-bubble economy stays in recession.

Will the recession be so severe that it will count as the ‘millennium depression’? The size of the US bubble, its inept government and business responses thus far, and the already rising public debt are not encouraging. On the other hand it is said the US will be more ruthless jettisoning weak firms. I reread my recent Listener columns on the world economy to write this column. They are available, with a commentary, on this website. See if I have got it right so far.)