If a prediction of a recession causes the market to crash, can it be said that the prediction itself is part of the cause of the recession? Like a self-fulfilling prophecy?
In: Economics
On the surface it only appears that way. In reality the recession/depression is caused by economic realities that run far deeper than it being merely a perception of coming economic crisis.
Let me give an example. Let’s say that there are two companies: A and B. Both make a very similar product that are in competition with each other, however they produce them under different conditions. Company A produces 1 million units of the product per year using 10,000 workers. Company B also produces 1 million units but requires 15,000 workers to do so (their technology and productive techniques are inferior).
Over time it is easy to see that Company A will be able to undercut the prices of the product they are each producing. If there isn’t demand in the system for all 2 million units produced per year, then it is highly likely that Company B will be left with units unsold.
A successful prediction would determine that Company B needs to modernize its productive capacity to be better able to compete with Company A or be forced into bankruptcy.
However let’s assume that the management at Company B doesn’t realize this. Let’s say that their suppliers and creditors don’t realize this either. Company B continues to produce 1 million units per year as if nothing is wrong: perhaps they see their poor market performance as merely a ‘temporary blip in ‘the market.’ Their inventory of unsold units keeps increasing.
Rarely in large scale production are suppliers and creditors paid immediately. Instead they have ‘accounts’ that are ‘promises to pay later.’ In the case of Company B there is a huge supply chain that provides Company B with the materials they need to produce their units. In turn each of these suppliers employs many people and get their resources from their own suppliers and creditors. Many thousands of people are employed and have investments along this chain.
And then it happens.
Company B is no longer selling enough units to pay their employees, their suppliers or their financial creditors. They file for bankruptcy which effectively writes off most or all of their debts. Their productive assets aren’t worth much (it’s not modernized, remember?) so it doesn’t count for much when paying off the long line of people that are owed money. They also lay off their workers.
Their workers, now unemployed, have
debts of their own: mortgages, student loans, car leases, lines of credit, credit card debt, etc. Many of these debts now won’t be repaid, creating the potential for crisis in other sectors of the economy.
Company B’s suppliers not only have to write off the money they were owed by Company B, but they no longer have new orders to fill from Company B. If they don’t scale back their own production in time, they too might suffer the same fate as Company B. These suppliers in turn have their own suppliers of resources. In short: it is quite easy to see that a company going bankrupt can wreak havoc all along its supply-chain.
The financial institutions that lent money to Company B will likely not recoup all of their money (or perhaps even any of it). They too have employees and suppliers with debt obligations of their own.
Generalizing this scenario across the economy is known as economic crisis, or recession/depression. Due to the large amount if unsold goods prices tend to drop as companies are forced to sell off their over production. Employment drops too which exacerbates the possibility of crisis. Wages/salaries drop as the army of unemployed grows and people are willing to accept less pay just in order to have a job. And last, production drops as companies are forced to slash production.
If everyone were to pretend that nothing is wrong, the problem would only get worse. While there are some conditions in which it is mere perception that can launch a recession, in most cases economic crisis is the result of actual economic conditions. These conditions are inherent to competitive market economies.
Latest Answers