Looking at the Business Cycle as an MBA Rather Than an Economist: The Effect of Organizational Dynamics on Recessions

I will confess that there is much about advanced economics that I have trouble following, because I just don't have the background.  I suspect I am more comfortable with a mal-investment model of recessions because it is something I can see and understand as a business guy, whereas when talk gets into monetary policy I can quickly get lost.

For example, in this Arnold Kling review of Scott Sumner's book on the Great Depression, I totally get this:

Sumner's theoretical framework starts with a straightforward explanation for fluctuations in employment and output. Large shortfalls in output and employment occur when relatively flexible prices fall in relation to relatively sticky wages. When firms face high wages and low prices, they have to cut back on employment and output.

A business guy (outside of a commodity business) would probably say he sees a fall in demand for his product rather than a fall in prices, but I understand enough economics to know that these are essentially interchangeable -- the business is seeing a fall in demand at the old price but would likely see the same old demand if the price were lowered.

However, when I read stuff like this, I start to get lost.

If investors believe that the future path of monetary policy is expansionary, then they will immediately start to bid up prices for sensitive commodities. This means that if the central bank sends a credible signal today that it will maintain an expansionary stance going forward, this can quickly raise prices relative to wages, leading to a rapid expansion of employment and output.

I understand it intellectually, but I certainly don't go on a buying spree the moment the Fed announces more QE (though in retrospect looking a the rise in financial asset prices over the last few years, I should have).

But where I was going with all this is there are real-world effects that I am positive contribute to the depth of recessions that I seldom see in these economic theories.  For example, economic theories tend to assume firms are properly staffed heading into the downturn, such that layoffs are driven by the fall in prices/demand.

But that is not ever the case.  In my experience, it is an iron law of organizations that their staffing grows fat in the good times.  No matter how tough or attentive the management, firms will put on too much staff.

My personal theory is that organizations have a life of their own.  Almost literally.   In many ways the organization acts as a living entity with a mind of its own, trying to grow and feed itself.  It does not consider what size it should be, any more than a deer heard is concerned about its size vs. the available food supply.  It will keep growing until it is culled by an outside  force (lack of food or a predator).

I think of organizations the same way, and the only way to check its growth is with active management from the top.  Managers have to constantly stay on top of the organization's size and be pruning or culling it constantly (depending on the metaphor you want to latch on to).  However, because of scale economies, profits tend to grow faster than revenues at the top of the business cycle.  This creates a certain comfort level among management, and since pruning the organization is emotionally difficult -- at the least saying no to people's resource requests and at the most demanding layoffs --managers don't keep up with their job in this area in the good times.  No one notices that a 15% profit growth could have been 20% if they organization had properly been kept in check.

Then comes the downturn.  Demand and/or prices are falling, and profits are falling faster than revenues, and the crisis is now at hand.   Now that we have overcome whatever emotional starting friction there is to have layoffs, we might as well do the job right and cut not only what is required to keep up with falling prices, but we might as well take a look at the bloat we accumulated in the good times and right-size that away as well.  In fact, many businesses I have worked for or with as a consultant like to overshoot what they might have previously thought of as the right-size point, and cut even deeper, hoping that the limited resources will push the organization into finding new inefficiencies in how it does things.

And thus, in my view, the degree of layoffs in a recession will tend to be larger than that one might predict solely from sticky wages and declining  prices/demand.

By the way, for those of us who are skeptical about the government's ability ever mange a task efficiently, this organizational theory is one explanation.  Often commenters make the mistake of assuming that when I criticize tendencies in government organizations to look after themselves (rather than their mission) that I am singling government out as somehow operating differently from the private world.  That is not true.  Government is made up of the same human beings as businesses (though perhaps there is some negative self-selection) and government organizations are going to have the same tendencies as private organizations.

The difference is one of correction mechanisms and incentives.  Eventually, the private organization must clean out the bloat or else it will fail and go out of business entirely (unless of course the government bails it out, see: GM).  There is no such accountability with government organizations.   They just deficit spend or demand more taxes when they get bloated.   Making this worse are the incentives of  government agency leaders.   Lacking a profit metric or even a customer service metric, government agency managers typically get their pay and prestige set based on the budget and headcount of the organization they run, so cost and headcount cutting run directly counter to their incentives.  Combine this with higher barriers in government organizations to cleaning house (e.g. public union power and politicization of what should be efficiency decisions) and we get the dysfunctionality of government.  But again note, this is an issue of accountability mechanisms and incentives, not of having better or worse or smarter people.

  • Dan Wendlick

    I think both the malinvestment and monetary models can be right, in that there can be more than one kind of recession. I think the current situation is more caused by monetary factors.
    My probably imperfect understanding of macroeconomics goes something like this:
    Economies produce goods and services that have value. People use money to measure and exchange that value. Central banks are supposed to exist to keep the amount of money in the economy equal to the amount of value in the economy. The result of this is price stability.
    What happened since 2008 is that the central banks have been deliberately pumping too much money into the economy in the hopes that value would catch up. The current drop in the prices of commodities and financial instruments is this premium of money over value being removed rather forcibly.
    Now the Gold bugs say that the solution of this is to fix the supply of money. My contention is that this would either lead to limiting the creation of value in the economy to the growth of the gold supply, or create falling prices due to less money being available per unit of value.
    Engineers say fast, right, or cheap, I can give you two of the three. The economists analogous statement is economic growth, gold standard, or price stability.

  • Shane

    That is the problem with most economists when they approach the economy it is like a multi-variable calculus equation they hold certain variables constant. This may well work to solve for particular aspects of the equation but mostly this approach is grossly mis-representative of the whole equation and even the small part that was being solved is really a sub equation and has only marginal bearing on the main equation. The thinking of economists is the same thinking behind A Random Walk Down Wall Street. It is also the same thinking of central planners and government lovers in general ... static. People and industries interact and relate to each other in complex ways and measuring it changes the interaction. Humans always move toward simplification and that can cause problems or in the case of markets mis-allocation.

  • Peabody

    I've always contended that if economists actually knew half as much about macroeconomics as they claim they would all be filthy rich.

  • LoneSnark

    The behavior you are pointing out here is obviously correct. So, tack it on top of all the other behaviors and mechanisms taking place across the business cycle that act as positive feedback destabilizing the economy. Hence, we won't always have an identifiable cause for most recessions we enter.

    Another one is the inefficient firm issue. It isn't that once profits become losses every firm will right itself. Some productive assets have to go through bankruptcy to get right-sized, which is a legal process, not an economic one, with lots of resultant economic damages to the system (Think GM).

  • gr8econ

    Economists also have a problem with taking into account things that they have trouble measuring. Uncertainty is one of these. Businesses and households don't invest or spend when they are uncertain about the future. But since there is no agreed upon method of measuring uncertainty, economists ignore it and blame the resulting instability on "Animal Spirits."

  • gr8econ

    If pumping too much money into the economy was the problem, then one would expect to see commodity prices go up, not down. Likewise for financial instruments.

  • STW

    Parkinson's law.
    https://en.wikipedia.org/wiki/Parkinson%27s_law

    As I recall from another article on the law, bureaucracy (government or business) has a natural growth rate of around 2% a year. Downturns force business to trim, resetting the base; government just keeps rolling along.

  • Dan Wendlick

    What I'm saying is that the price increases in commodities and financial instruments from 2008 to last fall was more inflation than actual appreciation. Commodities prices were not driven by increasing scarcity of resources or demand for finished goods. Stock price increases were not driven by forecasts of increasing earnings (if anything the forecasts of increasing earnings were caused by the increasing stock prices).
    Crude oil was especially hard hit for several reasons:
    Technology changed allowing for a higher recoverable fraction from what had been considered problematic fields
    High prices made much of that new technologically recoverable oil economic to produce
    The flood of cheap money was available to fund a lot of drilling in these formerly problematic areas
    The assumption that Saudi Arabia in particular or OPEC in general could and would backstop prices failed for a variety of political, not technical, reasons.
    In the auto industry, the flood of cheap money made monthly payments lower without impacting prices. However, there now seems to be a problem with "channel stuffing", the big auto companies record a sale when the car goes to the dealer. over the past few months they've been shipping more cars than dealers are selling. Dealers can only carry this increased inventory as long as the flood of cheap money keeps interest rates at a manageable level.
    In China, money poured in to build steel mills. The mills turned out structural girders that got sold to builders. The builders put up huge apartment complexes and shopping malls that got sold to, well no one.

  • irandom419

    Reminds me when I was plotting the share of the economy by sector and the government share seemed to go up right before a recession as in everyone else contracted but government.

  • Tim Broberg

    Static friction > dynamic friction. Once things start sliding, there is less force to stop their motion.

  • mesocyclone

    Well said.

  • CT_Yankee

    Russia has vast resources, copper, diamonds, oil, wood, good agricultural land, and yet living conditions for most are near third world, while Japan has few natural resources besides the sea (fishing), and is clearly a first world nation. Better management is the difference. Now imagine Japanese management of Russia's resources....

  • tommy ex thom w ex tomw

    Said process of correction was short-circuited in the case of GM. Some inefficiencies were apparently 'too large to fail', and were carried over into the New GM. They were protected from the 'right sizing' and 'fat trimming' that would have occurred in a normal dip through the bankruptcy bath. The base problems were kept in place and will come to the fore down the road.

  • tommy ex thom w ex tomw

    Actually, I think the apartment complexes and malls were sold to families as their 'retirement nest egg'. Did not matter whether they were occupied and in use or vacant. They were buildings and buildings are 'real' and 'touchable' investments that people can have assurance in. They exist, they are mine, so my retirement fund is 'safe'.
    In the case of our economy, the 'free' money was used by corporations to buy up their stock, keeping stock prices high, with little to no investment in actual product capacity or plant. That had the effect of avoiding the inflation that excess money would normally cause because the dollars went into 'stock', not out to the normal consumer market where they could have/would have bid up prices for items. The consumer didn't have the money being printed, so didn't spend it. Combine that with slow or no growth, minimal wage increases if any, and rising commodity prices (food and fuel until late), and you have a stifled economy that is suffering an additional burden of enforced health care 'limits' that put a binder on employee hiring, and had the 'early firing' effect of the year lead time on calculating 'normal employee count'.
    Gee, isn't the planned 'economy' wonderful? phooey.

  • ErikTheRed

    Thank you. Every once in awhile I feel like I'm the only one rolling my eyes at the "animal spirits" thing (and I think "sticky wages" and other concepts fall in the same category). Why not blame economic issues on Mercury Retrograde while they're at it? Or Global Warming? Whoops. they do that one.

    The deeply scary thing is that people with considerable degrees of power and influence take this stuff very seriously. Heck, even my daily brokerage reports are written in terms of markets having some weird mind of their own (sort of the Keynesian version of "Muh Feels"). It seems like at least once a week I'm somewhat surprised I don't read the sentence "Just like the old gypsy woman said!" (yes, I'm throwing an Archer reference into an econ discussion) in these emails.

  • ErikTheRed

    On the government side, a fellow by the name of Ludwig von Mises wrote a book explaining why this is and why the problem will never go away (because it can't). It's short, and it can be downloaded for free:

    https://mises.org/system/tdf/Bureaucracy_3.pdf?file=1&type=document

    Note that this was written in 1944... and sadly the view of America then does not apply so much to the American of today.

  • Seekingfactsforsanity

    "Eventually, the private organization must clean out the bloat or else it will fail and go out of business entirely." Absolutely - and basic economics says that is true. But sometimes the private organization bloats but is saved by “dark economics” and has an extraordinarily long and profitable life anyway - or an extraordinarily long death cycle – simply because it is protected by the unaccountable bloat of
    government. The government’s ability to “…just deficit spend or demand more taxes” is infectious and benefits some very large private organizations. Government bloat infects all aspects of the economy. And this infectious disease has made basic economics inapplicable, and created “dark economics” - a form of economics that is, at minimum, difficult to understand because it has added a much larger and less visible variable - protection offered through political, government bloat .

  • Daublin

    There's an additional reason for laying off in bulk: it's much more efficient. When you fire an individual person, they are more likely to object and more likely to succeed in their objection. If you fire 1000 people, fewer people object, and fewer outside observers will listen to them.

    You mentioned individual firms, but there is a related effect across multiple firms. Company leadership will seize on a claimed problem with the larger economy as a reason that their company should start downsizing in one way or another. On the margin, this will teeter companies over the edge toward downsizing that might not have done it without the wide-spread meme that there's something bad going on. This causes multiple companies to all downsize at the sime time.

  • stan

    Sumner needs a serious dose of humility. A while back he was pounding the table that Bernanke's problem was that he wasn't printing nearly enough money. All based on Sumner's monetary policy model. Which of course, is based on his supposed ability to use regression analysis to mine all the economic data of the past to determine the one true response of an economy to changes in monetary policy.

    The idea behind flooding the economy with cash is that businesses will see their balance sheets flush with cash and be fooled into thinking times were good such that they should expand, build more capacity, hire more people (and that they are too stupid to ever learn from the past). I put up a comment on his website post saying that a better idea would be to talk to the businesses who had record amounts of cash on their balance sheets and yet, were still not spending it. Instead, they were hoarding it. Why? The regulatory burdens of Obamacare, Dodd-Frank, EPA, et al and the uncertainties of just how bad the future would be. And the fact that the Fed chairman was making headlines telling the world that he was doing unprecedented stuff because the economy was so damn bad.

    Sumner responded by writing that talking to businesses would be the dumbest thing we could possibly do.

    He had all the answers in his model. What more information could possibly be needed?

  • stan

    Note also, economists don't have a number to put on the regulatory drag of government. So they don't model it well, if at all. Like looking for their keys under the street light.

  • stan

    or at least wiser and more humble

  • stan

    Indeed. Obamacare hammered the economy. What 'number' did economists plug into their econometric model to represent the fear and uncertainty that it caused businesses?

  • tfowler

    There are estimates of the costs of regulation, but there is no consistent fully agreed on estimate, and such estimates tend to be expressed as a dollar cost not a reduction in growth. Also quite a few economists are supporters of big government, and as such they are less likely to call attention to things that could be used for arguments against big government.