The Economy Is Booming. Why Don’t Firms Believe It?

The basic idea is that changes in the level of investment impact the level of present consumption at the same time as changes in the level of investment rely on changes in future consumption for validation. The trouble comes in from trying to relate these two together in a way that makes sense in the long term. This is a really turgid couple of sentences, but what they mean together should become clear soon.

First, imagine there’s a stable growth-investment path. I know that’s a silly idea, but hear me out about how it would work. In the economy, every investment increases productive capacity, otherwise there’d be no reason to invest in it. In a capitalist economy, every investment also needs profits to validate it in the future, usually by having people buy the things that that investment makes. If that doesn’t happen, people give up investing, either because they go bankrupt or it just seems not worth it. At the same time as this is happening, the increase in investment also increases aggregate income, and thus present consumption.

On a balanced path, the increased consumption from the increase in income creates the future consumption needed to validate present investment. Capacity utilization stays stable, while investment, consumption and income all rise stably and in tandem. Everything is perfectly even, everyone gets richer, no one makes a mistake.

The problem is, entrepreneurs use current demand as a big part of forming expectations about future demand. This is natural, and common to Keynes: unless you’ve got good reason to believe something different, then the present provides a pretty good guide to the future.

This is all well and good, but the problem is that the level of investment influences the level of current demand, and the level of current demand influences expected future demand, which in turn influences the level of investment! It’s a loop! If you’re increasing investment in aggregate, that means more folks are being hired on, and aggregate income is rising, so aggregate consumption is rising. As soon as the economy deviates from that stable growth-investment path, the contemporaneous effects of changes in investment on consumption feed back on one another, and start screeching like an amplifier.

So, imagine the level of investment is for one period higher than this stable path. This increase in investment leads to an increase in demand, because the investment creates jobs and income that are spent on consumption. Firms in aggregate will see this unexpected bump in demand, and think “ah! We underinvested in the last period, time to ramp up investment to meet demand!” In the next period, they invest even more, but still see even more new demand, because the added investment has created it. This cycle spirals upward until something bad happens – doesn’t matter what, anything that makes it suddenly really obvious that there’s too much capacity and consumption can’t keep up – and suddenly a bunch of investments aren’t being validated anymore. Everyone sees this and suddenly stops investing, demand craters, and takes employment with it.

Even worse, the same thing happens if you accidentally drop below the balanced growth-investment path as well. If firms invest less than is needed for there to be sufficient future consumption to validate their investment, they will all feel as though they have overinvested in the past, and cut investment further!

In this model, overinvestment feeds overinvestment, and underinvestment feeds underinvestment, and as soon as the system leaves the balanced path, it has no clear way back.

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