Transcript | 1. lecture: About the causes of recession (Vladimír Vaňo) - University for modern Slovakia

Burn the cottage, overcome the winter:

• The global recession that we went through in years 2008 and 2009 is often given as an argument to question the functioning of the market system to the market relation organisation.
• Regularly recurring recessions are the proof of an effectively functioning market system that manages to identify temporary imbalances in the economic development but also manages to even them out.
• Recession, the vulnerable time in economy, is a time of hygiene to even out accumulated imbalances, whether it be inappropriate allocation of production funds to certain sectors or the inappropriate level of prices.
• The critique of the market system for the recurring recessions resembles the effort to burn a cottage during the regularly recurring winter.
• It is not possible to avoid the seasons or phases of a business cycle. Even history teaches us that.

A glimpse into the history:

• The recession in Slovakia is perceived with an increased tension mainly due to a very short history of the market economy.
• A short and mild recession was in Slovakia at the end of a decade, in year 1999. A part of the solution for its effects were deep economical reforms after 1998, thanks to which we were enjoying an especially strong expansion in years 2001-2008.
• The strength of the expansion in years 2001-2008 was supported by the fact that with the massive inflow of direct foreign investments, the potential of the Slovak economy increased, especially in the export focused industry.
• That’s why the strong growth from years 2006-2008 couldn’t be labelled as unhealthy and in contrary to years 1995-1998 didn’t lead to any economical overheating.
• However at the same time in the last decade it came to an enhancement of business exchange mainly with countries in the Euro-zone, including Germany. As a consequence of the strong link to the foreign market was the dependence of the Slovak business cycle on Germany (20% of Slovak export) and Euro-zone (more than half of the Slovak export) deepened.
• This was also the case of the recession in 2009, into which Slovakia fell because of the weakening of the external demand of our export to Germany and the Euro-zone, which noted a decline of business activity already in 2008.

Why do recessions recur:

• The economist Nikolaj Kondratiev came up with the academic theory of long term business cycles after the first world war. The Kondratievov wave, sometimes termed the long technological cycle, should according to his theory last between 45 to 60 years.
• In his theory had the cycle three phases: expansion, stagnation and recession. Nowadays we talk about four phases, including a point break. In the nineteenth century identified Kondratiev two of such long term cycles.
• According to the technological innovation and complexity theory are the causes of these long term business cycles revolutionary innovations that lead to technological revolutions. Those will cause a boom in the most important sectors by an increase in productivity.
• We could label the following examples as the key technological innovations:
  • steam machine invention (around 1800)
  • railway boom and the invention of steel (around 1850)
  • boom in the chemical and electrotechnical industry (around 1900)
  • boom in the oil and car industry (around 1950)
  • boom of information technologies (around 1990)
  • A version of the long technological cycle has also been developed by an Austrian economist Joseph Schumpeter. However according to him the vicious circle between production and consumption without innovation leads to a state of stagnation. This is disrupted by the businessman who according to Schumpeter is the main driving force of the economical development which takes place in the cycles.
  • In Schumpeter’s theory of the business cycle, where the main driving force is innovative initiative of a businessman is the long cycle consisting of numerous short term ones:
    • Kondatierov’s long technological cycle lasts 45 to 60 years
    • Kuznets’ infrastructural investment cycle 15 to 25 years
    • Juglar’s cycle of tangible fixed assets 7 to 11 years
    • Kitchin’s inventory cycle 3 to 5 years
    • Reasons for these short term and long term cycles vary:
      • Kitchen’s short inventory cycles lasting 3 to 5 years are caused by a time shift of the information flow that influences the decision making of production companies, including all parts of their supply chain:
        • Increase in demand causes the rise of prices and increase in production and goods supply.
        • With a cyclical decrease of demand and market prices there is still an increase in unnecessary supplies that inform the businessman of the need to lower the production.
        • Reasons for stock holding:
          • Securing an equal production during short term fluctuations of demand.
          • Achieving savings from the extent of larger production.
          • Creation of supplies for unforeseen changes in demand – to avoid loss of revenue (transaction motive)
          • Use of lower prices (speculative motive)
• Jurglar’s 7 to 11 year cycles are caused by the fluctuations in the amount of investment into fixed assets (Clement Juglar). Causes of these longer cycles are similar to the inventory cycle, their longer duration is related to a longer life of fixed assets.
• Kuznets’ 15 to 25 year cycles are associated with a different intensity of construction, residential and infrastructural. (Simon Kuznets) They have 4 phases:

1. Building phase: the demographical development encourages the renewal of demand followed by an increase in new buildings.
2. Building excess phase: after the saturation of the initially increased demand there are more freshly-started constructions than it is possible to sell.
3. Correction phase: decrease in prices gives a signal that leads to a decrease of the number of freshly-started constructions.
4. Acquisition phase: the decreased amount of freshly-started constructions continues but thanks to the decrease of prices there is a relatively stable amount of sellable estates.

When do we talk about recession:

• By textbook is the start of a recession defined as a phase when the economy notes two consecutive midterms of an interannual weakening of the real economic activity. Because the statistics of the GDP growth are available only ex post, we are certain of the start or end of a recession with a considerable delay.
• NBER – The National Bureau of Economic Research that is given the role of deciding when a recession in the USA begins and ends uses for monitoring of the breaking points a number of regularly accessible indicators:
  • Real GDP growth.
  • The number of newly created jobs.
  • The development of the real incomes of households.
  • Production industry development.
  • The development of the real industrial revenue.
  • Early indicators based on research on trade managers, managers of stocks/logistics in services and industrial companies, are a helpful indicator that signalises a threat of an economical slowdown  in advance.
  • In the case of German economy is the business confidence  index, which is given by the IFO institute, a very good early indicator of a business cycle.

The role of trust in a business cycle:

• The indicators of business and consumer trust, perhaps even the early indicators of activity according to research on trade managers, are labelled as the so called soft statistics measuring the subjective evaluation of the situation in businesses or between consumers.
• Nevertheless have these indicators been shown to be good early barometers of the subsequent actual development in the real economy, hard statistics (GDP, revenue) measure this ex post.
• This close relationship between optimism/confidence of businesses and households in the future and the real development of a business cycle helps to explain the theory of business cycle and its individual aspects and causes.
• Especially the sudden negative shocks to the business and consumer trust can therefore significantly enhance the weaker phases of a business cycle.
• There was a proof of this in year 2008: the American recession that has already started in December of 2007 which was deepened after serious turbulences on Wall Street in September 2008.
• Turbulences in the financial market are not only a signal of changes in the availability of the capital to private businesses, but it also effects the behaviour of consumers through retail investments and a so called “wealth effect” of which the paper value temporarily decreases during a recession.

The characteristic development of a recession:

• V, U, W, L
• V- clearly defined bottom and a strong recovery.
• U- a longer recession and less defined bottom.
• W- a short phase of recovery is followed by a recurring recession.
• L- a Japanese scenario, a radical weakening of production is followed by a very slow recovery, in other words a stagnation.

The best treatment is prevention:

 There is a lot of discussion about recession, mainly because the business cycle has a direct effect on the tax income of a country. And because the spending behaviour of the government is less flexible than the changes in the economic growth, a more rapid decrease of the income in times of a recession leads to the deficit in the national budget, and so to a debt that increases every year.

• Criticizing the business cycles or market system definitely isn’t the solution to these problems which is especially true for small economies.
• The saying about how the best treatment is a timely prevention pays off even in case of the relationship between public finances and business cycle.
• A liable public funds management should therefore follow a very simple rule, similar to house management. In good times, times of development, to manage with equilibrium or even a surplus budget, so when a recession linked with a decrease of income comes it wouldn’t catch us unprepared, but on the contrary, allowed us to manage with deficit. It is the rejection of this simple logic of the relationship between public funds and business cycles that is the core of the debt crisis problem that we are facing right now.