Brad DeLong wrote a simple explanation about why recessions happen and how this idea was first developed in the early 1800s. First he explains that inflation happens when there is an increase in the supply of money relative to the demand people have for using money in market exchanges of goods and services. Then, when there is too little money relative to the amount of goods and services that are wanted, a recession, or “general glut” happens because money demand increases when some people hoard money rather than buying goods and services.
Sometimes when you go the market, you find the money prices that you have to pay higher than you expected—perhaps 10% higher than you expected last year when you made your plans. It seems that, somehow, there is too much spending money chasing too few goods.
When the money supply grows faster than the supply of goods, we get inflation because people have more money without getting more goods and so they become willing to spend more money on each good they buy. That is a rise in prices (inflation).
Conversely, we can have the opposite problem—not a glut of money relative to goods, but what early-nineteenth century economists used to call a “general glut” of unsold commodities, idle factories and workshops, and idle workers all across the economy. Economists have important things to say about how to try to prevent these episodes and what to do when they happen to cure them…
Back in the 1820s the question of whether the circular flow of economic activity as mediated by the market system could break down and the economy become afflicted by a “general glut” of commodities was a live theoretical question. Everybody agreed that there could be particular gluts [in the market for a particular good like electricity, but there was disagreement whether all goods and services markets could have a glut at the same time].
Consider what happens should households decide that they want to spend less on electricity to power large-screen video and audio entertainment systems and more on yoga lessons to seek inner peace. The immediate consequence… of this shift in preferences is excess demand for yoga instructors and excess supply of electric power. Prices of electricity (and of large-screen TVs, and of audio systems) fall as unsold inventories pile up in stores and as generators spin down and stand idle. Yoga instructors, by contrast, find themselves over scheduled, working ten-hour days, and stressed out—and find the prices they can charge for their lessons going through the roof. Workers in electric power distribution and in video and audio production and sales find that they must either accept lower wages or find themselves out on the street without jobs.
Over time the market system provides individuals with changing incentives that resolve the excess-supply excess-demand disequilibrium. Seeing the fortunes to be earned by teaching yoga, more young people learn to properly regulate their svadisthana chakra and teach others to do so. Seeing unemployment and stagnant wages in electrical engineering, fewer people major in [it]. The supply of yoga instructors grows. The supply of electrical engineers shrinks. Wages of yoga instructors fall back towards normal. Wages of electrical engineers rise. And balanced equilibrium is restored. Thus we understand how there can be a glut of a particular commodity—in this case, electric power. And we understand that it is matched by an excess demand for another commodity—in this case, yoga instructor services to properly align your svadisthana chakra.
But can there be a general glut, a glut of everything?
Some economists early in the nineteenth century said yes. Other said that the idea of a “general glut” was logically incoherent. Jean Baptiste Say, for example, [in his 1821 Letters to Mr. Malthus]:
I regret to say, that I find in your doctrines some fundamental principles which… would occasion a retrograde movement in a science….
What is the cause of the general glut of all the markets in the world, to which merchandise is incessantly carried to be sold at a loss?… Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for…. From these premises I had drawn a conclusion… “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”…
[W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandise, it is because other articles [in excess demand] are not produced in sufficient quantities… if those who produce the latter could provide more… the former would then find the vent which they required…
Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: “every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared…” The general glut, Say wrote in 1829, had been triggered by a panicked financial flight… in financial markets. What was going on? The answer was nailed by John Stuart Mill:
Those who have… affirmed that there was an excess of all commodities, never pretended that money was one of these commodities…. What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute…. The result is, that all commodities fall in price, or become unsaleable…. [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence…
Note that these financial excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy…, et cetera.
It seems as if there is …almost always something that the government can do… that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets–as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera…
And what if there is a glut not of commodities but inflation? Simply apply the same policy tools in reverse.
That is the last of the six things economists have to say in the public square: that the economy does not consistently balance itself at high employment with stable prices. The principle that it does economists have called Say’s Law—even though Say abandoned it by 1829. And it is important for economists to say, loudly, that Say’s Law is not true.
Modern era recessions are almost always caused by someone hoarding money without even realizing that they are doing it. GDP statistics divide up spending among four groups of people: 1. Households (Consumption spending), 2. Businesses (Investment spending), 3. Government, and 4. Foreigners (Net export spending). In the US, you can mostly blame businesses for increasing hoarding during a recession. That is why we commonly call a recession and expansion a “business cycle”. When businesses get scared about future profits, they cut their spending on capital investment to hoard more of their money for the hard times that they foresee and that is the main cause of recessions as measured in the GDP statistics.
Banks can also hoard money during recessions because they get scared about lending out savings and they raise their lending standards. That further depresses business investment spending because savings don’t get lent back out to stimulate the circular flow.
Households try to pay down debt during recessions which just increases the money that is being hoarded by banks. Consumers are forced to hoard money because unemployment rises and unemployed people have to cut back spending. Even workers who keep their jobs are more worried about layoffs and tend to delay buying new cars or any purchases they can put off. Even so, American consumers are so dedicated to consuming that overall consumption spending doesn’t change much, but it does have an impact.
For a more formal explanation, see my algebraic hoarding model.