Hangover Theory

Karl Smith explains what’s wrong with the view that today’s recession is punishment for yesterday’s overindulgence:

[W]e say that Germany’s economy seems to be recovering. However, consumption in Germany is not rising. Consumption is flat. Working is rising. Employment is rising. That is what it means to be doing well. It means that more people are doing more work.

This is why it makes no sense to say that a recession is inevitable because we overconsumed. Because we bought too much it is now inevitable that we work less? Why does that make fundamental sense? Surely something is going wrong. Shouldn’t we be working more to pay for all the stuff we bought.

This is what Paul Krugman called the hangover theory of recessions back in the late 1990s and it appeals to people because the moral logic is compelling. But as Smith points out, it doesn’t make sense because of the fundamental difference between production and consumption. It’s true that in the past we were consuming more than we produced and that level of consumption was unsustainable. But the need to bring consumption down below the level of output is no reason output has to fall.