Friday, July 24, 2009

You Call That A Recovery

Economic activity can be broken into 2 categories: production and trade. In abstraction, both can be analyzed identically because production is actually a type of trade.

Trade, as we typically think of it, creates value by putting goods and services into the possession of the people who value them the most. Trade effectively funnels products to their highest-valued use.

Through production, we trade basic resources for finished products. The other side of the production coin is destruction. The inputs are sacrificed so that we may have the output.

There is no guarantee, however, that the output is of higher value than the inputs. We must be careful what we destroy.

If a business loses money in the long-run (that is, if total cost exceeds revenue), that business is destroying value. We know this because costs can only exceed revenue if the group of inputs has greater value in some other capacity. Unfortunately, value-destroying processes enter into GDP positively; they are really a negative. GDP is a very poor measure of the health of our economy.

It is commonly believed that any production process adds value because the finished product can be consumed whereas the raw resource would sit idle otherwise. But that ignores the possibility of using those resources for something else. There is also value in having the option to use a resource in the future.

There will always be some waste in the economy. We do not have perfect foresight, so we are unable to limit our production to only those that create value. Usually they are a very small portion of total production. Recently, destructive processes (example: General Motors) have been a relatively large share of the total. The result: recession.

The proper response to a recession is twofold: acceptance and recovery. Acceptance means stopping the destructive processes. Recovery means taking the resources that were involved in the destructive processes and finding better ways to employ them.

Acceptance can be quite painful. It involves things like bankruptcies, job losses, foreclosures, asset price declines. But, it is a necessary pre-condition for recovery.

The paths of acceptance and recovery vary in different sectors of the economy and for individual economic agents, and they can coincide to some degree. But acceptance can also be mistaken for recovery.

For example, when a business increases profit by cutting cost (i.e. contracting production) that is acceptance. They are lessening or eliminating the destruction of value. This is why we should let failures fail gracefully instead of bailing them out.

Thus profit can increase as GDP contracts and, importantly, we are better off, on average, as a society as a direct result of this contraction. This might be what people mean when they say 'jobless recovery.'

Make no mistake, though, there is no such thing as a jobless recovery. Labor is the most important input to production, and employment is the best indicator that we have as to the real level of our output. If there are more willing workers sitting idle today than at the beginning of the recession, then we haven't recovered. If net job losses continue to occur, we haven't started to recover - because we haven't fully accepted our recession.

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