Are Economic Recessions Inevitable?

The popular sentiment of financial analysts and many economists is that recessions are the inevitable result of the business cycle in a capitalist economy. The empirical evidence, at least on the surface, appears to strongly back up this theory. Recessions seem to occur every decade or so in modern economies and, more specifically, they seem to regularly follow periods of strong growth. This pattern recurs with striking consistency, but is it inevitable? In other words, do recessions necessarily follow from periods of strong economic growth? Can recessions be avoided, or are they an unavoidable feature of a modern capitalist economy?

What Are Recessions?

“Recession” is the title given to an economic period marked by negative real growth, declining output, depressed prices, and rising unemployment, which often follows after a period of notably strong economic growth as measured by these same variables. Recessions are characterized by an unusual, simultaneous, and large grouping of business errors, which some economists call malinvestments.

Faced with financial loss and declining margins, businesses scale back production or fail entirely, and business managers (or the new owners) reallocate resources tied up in the failed projects to different uses. During the period of transition, some of these resources will need to be repriced (in terms of goods prices, asset values, or in the case of labor, wages) and some will remain idle for some time until a new use is found. As this process proceeds the economy recovers.

Where Do They Come From?

The key issue as to whether this process of growth-recession-recovery is inevitable is what causes the cluster of business errors to occur? Why can businesses not continue to grow and asset prices continue to rise indefinitely? Economists have developed numerous explanations for these clusters of business failures over the years. 

Some rely on psychological factors. These explanations point out that people can be prone to excessive optimism and confidence or pessimism and fear, leading to the propagation and collapse of market bubbles and persistent deficiencies of aggregate demand. Some of this can even be reproduced experimentally in the classroom, simulations, or experiments on a very limited scale. Such theories are very popular, but in general fail to actually explain how a large scale cluster of business errors can occur across markets and asset classes in an entire economy as happens during a recession.

Others point to economic shocks, which are random events such as wars or epidemics, that can negatively impact production, consumer demand, or the costs of key goods and commodities in an economy. These kinds of things can certainly hurt businesses across and economy all at once. However they fail to explain why recessions seem to occur with such regularity or why they consistently follow periods of notably strong growth. After all, economic shocks are by nature random events. There is no particular reason for random shocks to follow patterns like these, which are easily observed. Random negative shocks may be inevitable, but that doesn’t show why the observed patterns of boom-and-bust in the economy should be inevitable.  

Still others explain the recurrent cycle of growth and recession in the economy in purely financial terms. These often involve errors by the central bank or monetary authority that supplies money to the economy. Maybe too much new money leads to excessive inflation, but too little may lead to tightening credit conditions and defaults leading to debt deflation, and this is why we have recessions. However, these theories fail to explain why monetary authorities should err so greatly and with such apparent regularity as to cause a readily visible cycle of boom-and-bust in the economy. Essentially these theories simplify the question from “Why do clusters of severe business errors occur?” to the question of “Why should severe clusters of central bank errors occur with such regularity?”.

Each of these types of explanations for the cycle of growth and recession that can be seen over the decades seems to have some power and perhaps some bit of truth. But none of them really show that recessions are inevitable, or that a cycle of expansion and contraction in the economy should really exist at all.

Alternative Explanation

Another alternative explanation for recessions comes from Austrian Business Cycle Theory (ABCT). This theory takes a deeper look at many of the kinds of factors discussed above. It focuses on how central banking and monetary policy interact with real economic events and the psychology and incentives faced by investors, producers, and consumers in the economy. By looking at how all of these things relate to each other, we can get a more complete view of how business cycles work and whether or not they are inevitable.

In ABCT, the key cause of recessions is the creation of new money in the form of loans and corresponding deposits by the banking system, known as fiduciary media of exchange. Banks, and especially central banks, do this not out of an error of calculating the correct monetary policy, but because it is their essential business model. This sets in motion a series of investments in the economy, by distorting the incentives of investors, consumers, and savers in favor of debt financed investment and consumption and simultaneous decrease in savings. 

This creates a temporary illusion of a strong economy as prices and spending across the economy rise, but because the plans of investors, consumers, and savers are fundamentally in conflict, this illusion cannot last. Business investment projects previously expected to be profitable under the illusion of distorted incentives and the optimistic exuberance of the boom are eventually revealed to be a cluster of errors. 

Oftentimes this revelation of the cluster of errors may in part be triggered by some random economic shock, but not necessarily. The conflicts that arise as investors, consumers, and savers try to increase both present and future consumption while decreasing savings often take the form of real constraints and bottlenecks in supply chains which may resemble random economic shocks, though they are nonetheless systematically caused by the initial over issuance of new money and credit. These lead to business failures, rising unemployment, debt deflation, and all the economic pain of a recession. 

So Are Recessions Inevitable?

In the end, once the process of the artificial boom in the economy by the issuance of fiduciary media is set in motion, then bust and recession that ensues is indeed inevitable. But this does not mean that recessions are always and in general inevitable, other than after episodes of the inappropriate the creation of new money and credit. Recessions are not logically inevitable in any economy, but are contingent upon the monetary practices and institutions a society adopts. 

However, for better or for worse, all modern, capitalist economies include banking systems based on fractional reserve lending coordinated by central banks that routinely and continuously issue new fiduciary media into the economy. As long as this is the case, then the cycles of boom-and-bust that we regularly experience, as described by ABCT, will unfortunately be inevitable. Given the ubiquity and entrenched position of the current monetary arrangements, for the time being recessions are just part and parcel to the way our economy works.