As recession bites, economists should have known better

Why were so many economic commentators wrong in predicting what now appears to be a sharp downturn, if not an outright recession? Just a few months ago, commentators, including myself, were saying that the sub-prime crisis could be contained to the financial services sector.

Frankly, we should have known better. The economy is a web of inter-connections globally and the influence of the US economy over that fragile inter-dependence is absolute. Bad mortgage debts in the US fed through to the rest of the world and the rest, as they say, is history.

The speed of the collapse in economic confidence, and therefore business activity, that has followed is the result of the simple concept of derived demand—something economists ignore at their peril. Derived demand is the need for one good or service that comes (or derives) from the demand of another. If you buy a house, you will inevitably want to buy new furnishings, white goods and so on.

If the housing market experiences a substantial downturn, so too do all related sectors. Similarly, our need for oil is a derived demand that follows from the very fact that we are economically active: we cannot keep going without it. So, if the price of oil goes up, our life is more expensive across the board. Normally we would turn to credit but this is closed off as an option because of the sub-prime crisis that started off the process.

Could we have staved off some of the ripple effects if economists had looked at their own textbooks? Maybe not. Even so, it shows that some of the most complex things in economic life can be explained by simple economic concepts; something all economists would do well to remember.