Tuesday, December 16, 2008

Paul Samuelson's Brilliant Idea

As the US finds itself firmly in a recession, with the potential for this phase of the natural economic cycle to worsen before the economy recovers, I am reminded of one standout economic insight, about which I have written before, here and here.

I am referring, of course, to MIT emeritus/retired Professor of Economics and Nobel Laureate, Paul Samuelson's 'accelerator-multiplier' theory.

Regarding the current recession, I wrote in the second linked post,

"Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses."

As this phenomenon from the housing sector spread through banking and into the general economy, I have ruminated recently, at length, as to what factors can turn a deepening recession into an eventual recovery.

What is it that turns a gloomy consumer outlook, vanishing banking assets, shrinking spending levels and spreading joblessness into subsequent economic growth?

The answer, quite simply, was discovered by Samuelson in the 1950s. Inducing cyclicality into a system is often simply the result of including a 'first difference' term. Samuelson's genius was understanding that businessmen and consumers view the 'first difference' between today and some past period- say, a year ago- to judge whether things have gotten better, worse, or are unchanged.

Right now, a look backward shows that volumes are shrinking, so near-term economic behavior echoes this with more belt-tightening.

But in six-twelve more months, business volumes will probably appear flat. This realization will cause businesses and consumers to conclude that the bottom has been reached in this economic cycle. Sales aren't falling anymore, joblessness isn't growing, and economic activity generally has leveled out.

Since this will be a positive change in the rate of change, planning becomes focused on maintenance or growth, rather than more cutting.

Samuelson quantified natural human behavior for economic purposes in a manner never before articulated.

Of course, there is a huge implication due to Samuelson's work on the accelerator-multiplier theory.

It demonstrates a natural cyclicality to economic conditions that cannot be 'fixed' by any sort or amount of governmental intervention. As I noted in the more recent linked post, this is why one-time fiscal 'stimuli' never work. Only permanent tax cuts can deliver a lasting change in incomes that effectively shock the perceptions of businesses and consumers into seeing the present as better than the recent past, so to trigger expansionary activity.

Further, any promises of governmental program activity, e.g., infrastructure spending, won't do much for widespread business and consumer behavior, either. It is simply impossible to arbitrarily, or determinedly lop off the 'recessionary' phase of economic cycles. The latter exist for a reason, and give society the opportunity to clean out unsustainable, unprofitable businesses, recycling their resources for use in better business opportunities.

Not only does Samuelson's work give us confidence that every recession, in effect, automatically brings about its own consequent expansion, but it confirms that this is a necessary phase in national economic cycles.

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