Wednesday, 9 September 2009

Recession will happen again

The BBC reports that Alan Greenspan, the former Federal Reserve chief, as saying the financial crisis “will happen again.” Their web article concludes with the statement "It's human nature, unless somebody can find a way to change human nature, we will have more crises and none of them will look like this because no two crises have anything in common, except human nature."

Is it really human nature to assume that human created financial systems can't be changed and that we are not able to learn from past failures and make transitions to new systems that don't have some of the same flaws? I will accept that human knowledge is incomplete but I don't accept that we can't learn from failures. However, we do seem to be blind to faults in our financial systems. The solutions may be more difficult to resolve.

As I reflect on the economic system and the issues that have led to the recession, I am forced to consider some of the equations that might relate to its operation. I recognise that I am not attempting to model every aspect of the economy but there seems to be some fundamental requirements that are not satisfied by the current system.

In order to be able to sell all product that is produced and to avoid production for waste, the available product for purchase should not exceed the available purchasing power. The basic assumption is that the market should be able to purchase all production. If production exceeds the purchasing power then either product is being manufactured to waste or prices have to decrease.

However, there is a fundamental principle of cash flow is that for any economic entity and that is that the cash in has to be greater than or equal to the cash out. As a general principle, the amount received from the sale of product should exceed the costs of production. Part of the cost of production is wages, salaries, and dividends; the primary source of purchasing power.

All economic units endeavour to live within their income but income is related to what is produced. If the income is inadequate then the economic unit must borrow. Borrowing is simply a mechanism for redistributing purchasing power. This means that there has to be economic units whose income exceeds their spending.

Borrowing comes with a cost (interest) that increases the outgoing cash flow of the borrower. Consequently, the borrower seeks to increase their cash flow to ensure that they cover the increased outgoing. The interest charges reduce the borrower's purchasing power and increase the lenders.

Anything that upsets the balance between available purchasing power and available items to purchase is going to cause problems with the economic system. If an economic unit is unable to cover their outgoings then there is going to be an imbalance in the economic system that will need addressing. If that is addressed with further costs then that puts extra pressure on the available purchasing power. The result is recession and financial collapse.

The solution is some fundamental changes to the way that we think about economics and our understanding of a just economic system.

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