Most of us focus on decisions affecting our daily lives — earning an income, spending, investing and looking ahead to our retirement. Businesses face similar choices about production, advertising, workers and pricing. Economists call these types of choices microeconomic decisions.
However, we don’t live in separate economic worlds. Individuals earn income by working for businesses. Businesses earn income by selling to individuals and to other businesses. Governments levy taxes to support public services like national defense, the court system and roads.
Putting individual economic players together forms the macroeconomy. Until a century ago economists didn’t pay much attention to it, but then came the Long Recession of the 1870s, the Great Depression of the 1930s and other less serious downturns.
It became abundantly clear that changes in the macroeconomy could adversely impact households and businesses — even if those households and businesses were making the best economic decisions for their individual situation.
A great deal of brain power has been expended in the past century attempting to understand the macroeconomy — and particularly what causes it to periodically go into a tailspin. One conclusion is that the macroeconomy is inherently unstable and recession prone.
When the economy is doing well and expanding, sales and profits increase, incomes and optimism about the economy’s future grow. Lenders lower standards to allow both households and businesses to take on more debt.
All is well as long as the economy grows, and as long as nothing happens to disrupt the general optimism. Yet a small uptick in interest rates or lackluster corporate earnings is enough to upset the balance.
Once the general optimism is disturbed, people begin to worry. Investors sell rather than buy. Businesses delay expansion plans and cut payrolls. And some households and businesses find they can’t meet their debt payments. If lenders aren’t paid and depositors fear their money isn’t safe, a run on the banks can set off widespread economic panic and a macroeconomic recession — or worse.
We saw this scenario unfold during the most recent recession. Optimism about the economy and particularly the housing market fueled record-high debts in the early 2000s. But pessimism took over in the late 2000s, and the economy experienced the housing crash, debt defaults and the worst recession in 70 years.
So if we know that excessive economic optimism eventually leads to unsustainable borrowing and a recessionary correction, can public policy makers impose controls to stabilize the economy?
One option is for government to attempt to moderate the growth of credit during boom times. The Federal Reserve has some tools to do this, including the ability to limit the amount of bank deposits that can be loaned, as well as the interest rate charged on loans. Also, federal legislation passed in the aftermath of the recent recession has added some further restrictions on bank lending.
Of course, such controls and limits have downsides because they restrict the ability of borrowers to obtain funds which, in turn, causes the economy to grow slower than it would have without the controls. This is a common explanation heard today about why business expansion and job growth are lagging in many parts of the economy.
So our economy may have — as part of its nature — periods of ups and downs related to general feelings of optimism and pessimism. Do we have to live with this cycle? Thousands of smart people have tried to answer this question. You decide if they’ll ever get it right!
—Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences.