A rising cost that can turn expansion into recession

Couple quotes from Arthur Burns and Inflation (PDF) by Robert L. Hetzel.

Backstory:

Burns was the protégé of the American institutionalist and founder of the NBER, Wesley Clair Mitchell... In 1946, they published a comprehensive study of the business cycle, Measuring Business Cycles... Both achieved worldwide recognition as preeminent scholars of the business cycle.

Hetzel on Burns's view of the business cycle:

During expansion phases “firms will find their profit margins rising handsomely” and “people [have] a feeling of confidence about the economic future—a mood that may gradually change from optimism to exuberance. . . . The new spirit of enterprise fosters more new projects”. However, rising costs erode profit margins and eventually turn expansion into contraction.

That sounded right to me, at first: Rising costs eventually turn expansion into contraction.

But how can it happen? Doesn't a rising tide lift all boats? Unless we have something like an oil shock or, as in more recent times, a package of wrong-headed policies that create imbalances in the economy... Unless we have something like that to create imbalances, doesn't the rising tide lift all boats?

Suppose the rising cost is wages. Don't rising wages boost aggregate demand? And doesn't rising demand boost profit? If the rising cost of wages leads to rising profit, doesn't the problem solve itself? Granted, we could get inflation this way. But that's not the question. The question is whether rising cost turns expansion into contraction.

Certainly the situation is different if, as in 1973, the price of oil increases extraordinarily. That shock drew money out of the domestic economy, and within the domestic economy it created an imbalance favoring the oil industry. The oil shock created a cost imbalance in the economy. The imbalance caused the recession.

The oil shock is not a good example. Burns offers an explanation of the typical cause of the typical business cycle recession. What imbalance could cause that?

Surely not every recession is generated by a supply shock the equivalent of the 1973 oil shock. Few are. I'm looking for an example of rising cost that fails to boost demand and fails to boost profit and therefore results in recession. I'm looking for an example where imbalance is created.


In a normal economy, in a normal business cycle, what are the rising costs that do not lead to rising profit? At Chron, they offer the bleeding obvious:

Production costs are expenses, such as materials and labor, that your company incurs in the course of producing the product that you sell to consumers. In general, the lower your production cost, the higher your profit, or the amount you have left over after you subtract your expenses from your sales revenue.

Other things equal, any rising cost would reduce profit. Sure, the same way writing a check would reduce the balance in your checking account. But that's a micro example, and one so extraordinarily micro that it considers only the one check and its immediate effect on the balance in your account. Similarly, the Chron quote considers only the one situation, and considers nothing beyond the one consequence that immediately follows. These are two examples of what Henry Hazlitt called "the fallacy of overlooking secondary consequences."

Henry Ford thought that if he paid his workers enough, they'd buy cars from him. Ford was not one to overlook secondary consequences.

In general, as I see it, the lower our production costs, the less money our customers have, that they can use to purchase our products. This is just the opposite of Burns's view that, as a rule, rising costs bring on recession.


That reminds me...

Jeez, from ten years ago! Sometimes my memory is surprisingly good. My dad gave me an advertisement he'd received, a magazine-size flyer from Investment Rarities Incorporated.

In the flyer was an interview with Dr. Kurt Richebacher. Richebacher's first answer is the reason I kept Dad's flyer:

Q: Give us the cause of the profits problem.

A: Corporate cost cutting, for one. The widespread measures that individual firms take to improve their own profits have, in the aggregate, the opposite effect on the profits of other firms. Business spending is the key source of business revenues, not consumer spending. A retrenchment in business spending cuts business revenues. Higher profits and higher prosperity cannot possibly come out of general cost cutting.

Magnificent.

Again, Richebacher says:

Business spending is the key source of business revenues... A retrenchment in business spending cuts business revenues. Higher profits and higher prosperity cannot possibly come out of general cost cutting.

Richebacher is saying what I said. I'm saying what he said. In general, the lower our production costs, the less money our customers will have, that they can use to purchase our products. Higher profits and higher prosperity cannot possibly come out of general cost cutting.

This is the opposite of Burns's view that rising costs bring on recession. Thanks, Dad!


Rising costs, Hetzel's Burns says, turn expansion into contraction. But Kurt Richebacher says general cost cutting cannot possibly lead to higher profits and higher prosperity. I'm with Richebacher. And Henry Ford. And, by god, Henry Hazlitt, and this is the first time I ever said that.

So the question remains: What causes recessions? Curses! It still makes sense, what Burns said: Rising costs cause recession. But then, don't we also have rising costs during the expansion? You can't expand if you don't spend more. So it's not a sure thing that rising costs lead to recession.

Is there a way we might have rising costs that don't lead to rising profit? Well yes, you have the oil thing, where everyone saw cost increases but only oil producers saw profit increases.

In general, it is not likely that everyone's profit will increase more than their costs. Some businesses, some industries, will do better than others. Some of the unlucky will go out of business. Some of the others will pick up the slack. Small imbalances like that can work themselves out without causing a recession.

Okay. But we're talking about recessions, lots of recessions, one or two or three of them in every decade. And we're talking about some unidentified cost we are trying to find, a cost not offset by rising profit. A cost that typically leads to recession. And it would have to be something like the oil shock, where the one industry benefits at the expense of all the rest.

I know.

I know what it is. It's finance.


In The Wealth of Nations, Book 1 Chapter 6, Of the Component Parts of the Price of Commodities, Adam Smith wrote:

The interest of money is always a derivative revenue, which, if it is not paid from the profit which is made by the use of the money, must be paid from some other source of revenue... All taxes, and all the revenue which is founded upon them, all salaries, pensions, and annuities of every kind, are ultimately derived from some one or other of those three original sources of revenue, and are paid either immediately or mediately from the wages of labour, the profits of stock, or the rent of land.

When those three different sorts of revenue belong to different persons, they are readily distinguished; but when they belong to the same they are sometimes confounded with one another, at least in common language.

That confusion still exists, as Timothy Taylor points out:

The calculation of labor share involve adding compensation received by employees to "proprietor income," which is the labor income received by those who run their own business. However, proprietor income is conceptually tough to measure, because someone who owns their own business can receive both "labor income," as if the person was an employee of their own business, and "capital income," as the owner of the business. In the real world, these two types of payments are jumbled together.

The difficulty distinguishing between "labor income" and "capital income" is exactly the confusion described by Adam Smith. Another example, one that gets less attention, arises in the confusion of interest with profit, or rent with profit. Bezemer and Hudson would say it is confusion of the financial economy with the real economy. Now we're talkin.

In the real sector, you work for your money. In the financial sector, your money works for you. Or look at it this way: Real-sector business makes and services things. Financial-sector business makes and services money.

When real profit and financial profit are confused together, the difference between profit and interest is blurred. The difference between productive business and financial business is blurred. This confusion allows imbalances to develop: In our economy, before the crisis, the growth industry was finance. The crisis, when it came, was financial crisis.

In our economy, the confusion is so deep that productive business is called "non-financial".


Most of us have real-sector jobs. (Even people who work in finance are in this group. They work for their money, too.) And most of us have, or want to have, money in the bank. So we're in both worlds, real and financial, or at least we want to be.

The whole goal of having financial income (as with any income) is to increase it. So a big portion of the income that goes into the financial sector stays in the financial sector. Little comes out. This is what made finance a growth industry. It also creates imbalance. When you have money going into finance and not coming out, it is very much like when you have money going to the oil-producing nations and not coming out.

Oh, it comes out, yes, but it's not drinkin' money. It's on a leash. The oil producers' money comes out to buy up our assets. The money that comes out of finance, most of it, comes out in the form of loans, loans which bring interest back with them to the financial sector as the debt is repaid. This assures that there's more money in finance when a loan is paid off than there was before the loan was taken out.

Unlike rising wages, growing financial costs do little to increase aggregate demand, except in the financial sector. And the rising demand it does create, does little to boost profit except in the financial sector. One industry benefits at the expense of all the rest. Imbalances arise.

You want to see a rising cost that can turn an economic expansion into recession? Finance is that cost.