US recession and technology: another economic fallacy

Gerard Jackson
BrookesNews.Com
Monday 18 June 2007

Some readers have taken issue with Dr. Frank Shostak’s Can technology prevent a recession?. They believe that technology can avert a recession. The error here is the failure to distinguish between economics forces and technology. This is what happened during the “Roaring Twenties” and the booming ‘90s. In both cases the Pollyanna’s declared that a “New Era” had arrived and the dragon of recession has been permanently vanquished. If only that were true.

This kind of loose thinking led to the view that America’s last recession had not only left the country with excess capacity because of “overinvestment” but also with a “technological overhang”. The readers seemed to think that this alleged “overhang” which consisted of a range of new technologies had depressed the economy. If only investment were able to keep up with these new technologies the recession could have been averted, is the underlying refrain.

Some of you may have notices that this argument shifts from over-investment to an investment lag. Let us ignore the fact that the overhang approach contradicts the existence of general excess capacity which many erroneously attribute to aggregate overinvestment. In plain English, you cannot have both — and in reality you cannot have either. What is being overlooked is that at any point in time, and I mean any point, there always exists a range of new techniques and inventions which are more productive then the currently employed ones. What should be asked is why these techniques are neglected’.

The answer would be obvious to any businessman. In order to invest in these techniques and inventions businesses would have to scrap their present capital combinations in which a great deal has already been invested. Scrapping this investment in favour of new investments would impose losses on businesses The Bessemer process is a good example of what I mean. This revolutionary steel making process was invented in 1854 in Britain and within a short time massive investments were made in the process.

However, in 1864 Frederick Siemens invented the open-hearth method which was superior to the Bessemer process. By about 1901 steel production from the Siemens method exceeded production from the Bessemer process. So why did steel makers who had invested in the Bessemer process still stick with it after the after the Siemens method had long proved itself the superior technique?

(I still remember a couple of my university lecturers arguing that the Bessemer case was an example of the refusal of nineteenth century British businessmen to take risks. How these businessmen were supposed to predict the advent of Siemens’ invention is something these lecturers never revealed to us students).

It is very simple, really. The Siemens method wasn’t sufficiently economically superior enough to warrant the immediate scrapping of Bessemer investments. Those who lament this situation do not realise that businesses have to make decisions according to current and expected costs and revenues. The rate of return from investing in the Siemens method would have had to exceed the return from the Bessemer process by such a margin that the difference between their costs of production per unit of steel times the yield would have had to be big enough to make expenditure on the open hearth method worthwhile.

Put it another way. Old investments will be scrapped when the superiority of the alternative investment is great enough to compensate for the expenditure it requires. The Siemens method did not fit this bill. This made it preferable to operate with the obsolete Bessemer process until it was time to replace it or until the alternative method fell far enough in price to justify investing in it. The same really holds for any investment. That is why firms do not immediately rush out to replace their computers with the latest version.

Of course, this does not answer the question: Why do potentially profitable new techniques and inventions go unexploited? Because the savings are not immediately there to take advantage of them. Investment involves opportunity costs. When you invest in one technique that is a sunk cost — gone but not always forgotten. New inventions and techniques usually require a complex production structure. One only has to think of what goes into making computer chips to realise how complex and expensive these investments are.

And this finally brings us to the last US recession. The ‘90s monetary boom created masses of credit that were used as a substitute for real savings, making it appear that there were abundant savings to fund all new technologies. There wasn’t, something the recession revealed. Unfortunately, it appears that some commentators became so accustomed to boom situation that they interpreted it as normal. Even though reality has since dawned they still cannot seem to adjust to the fact that a situation where new techniques and inventions go unexploited is not only the norm it is also healthy.

When every so-called technological breakthrough and invention immediately attracts investment think of the South Sea Bubble. John Stuart Mill sadly remarked that these booms left many businessmen and eager investors “to repent at leisure”. And that was written about 178 years ago.

Gerard Jackson is Brookes’ economics editor