Let's say that we begin with full employment[75] and the right amount of money circulating in the economy to allow all legitimate transactions to occur. Now for some reason people's confidence in their ability to maintain living standards drops. It might be caused by a natural disaster, a financial bubble bursting, a significant rise in interest rates or a sharp increase in the price of an essential product such as oil. In these circumstances people begin to fear for the future and cut back on spending, repay debts, refrain from new borrowing, and hoard money. These activities take money out of circulation. In cutting back people don't reduce all spending equally, they continue to spend on things that give them the most benefit, but cut back on things that give little benefit. Although everyone will be different in these respects there will generally be a decline in spending on non-essential products, putting different business sectors under different amounts of pressure.
When money is removed from the economy there is an uneven reduction in spending, the less essential item producers suffering more and the more essential item producers suffering less.
The spending that did occur on non-essentials paid the wages of people who produced them and the profits of the business owners, so as more and more people stop buying them profits are reduced for these products. The producers cut back on production by laying workers off to try to minimise the number of unsold goods, and also reduce prices in an attempt to stay in business, but there are limits to how far they can reduce prices because they still have materials to buy, equipment and building maintenance to carry out and rents to pay, so profits and solvency are very vulnerable. Producers also sometimes try to reduce wages of remaining employees but unless it is done as a last-ditch effort to save the business it can be counter-productive by causing great resentment and loss of company loyalty. Eventually either production is cut back to the level that the market will still support or the business stops trading. In both cases workers lose their jobs and some others suffer a loss of pay, and these people then have less money to spend so they also cut back on non-essentials. This takes away yet more workers' incomes and owners' profits, and so it goes on in a downward spiral.
The spiral effect is a feature of the economy working in a wealth-creating loop: work - create wealth - earn - spend - obtain wealth - consume, and this feature multiplies the effect in terms of created wealth of there being less money in circulation. What happens is that the initial drop in spending reduces the wealth created during the first pass round the loop, then that loss in wealth itself causes a drop in money available for the second and subsequent passes - without any more money being removed. Let's say that £100 million is removed from circulation, then in the first pass round the loop £100 million worth of wealth is lost to production. That loss of wealth results in £100 million less income for workers, who are then able to spend less for the second pass, not the full £100 million but (say) £70 million because the original £100 million wouldn't all have been spent, some would have leaked out of circulation by the repaying of debts or hoarding as discussed above. So on this basis without any more money being removed every pass round the loop results in 70% less wealth being created than in the previous pass. Overall, for very many passes round the loop, there will be £333 million less wealth created in total[76] for a one-off reduction of £100 million in money in circulation. This is known as the income multiplier (in this case it multiplies a reduction in income) and is extremely wasteful because wealth that is not created can never be recovered. If money is repeatedly removed then the income multiplier magnifies the impact in terms of reduced wealth for every separate removal.
These effects and their causes are analysed in more detail in chapter 23.
How far this process goes depends on how strongly people feel the need to cut back and how much scope governments and central banks have to intervene to limit the effects. If the original cause of the problem is short-lived, limited in the scope of its effects or not too serious, and the government or central bank can lower interest rates in order to stimulate borrowing and spending, then the cutback will be relatively mild and the economy will soon bottom out at a lower level of wealth creation. This is a recession. If however the cause is long-lasting, widespread in the scope of its effects or very severe then the government or central bank will find that the normal levers available to them to reflate the economy are ineffective and the downward spiral will continue, money becoming ever more scarce and therefore more valuable, prices and some wages falling for more and more products, the extent of the fall being higher the less essential the product (Dalio 2015 Part I Chapter 2 pp11-18).
In this situation unemployment reaches very high levels and skills are lost, idle machinery becomes unserviceable due to lack of use and maintenance, and because of these effects the ability to create wealth declines. This is deflation, and in this form is very damaging to an economy. Once under way deflation tends to feed on itself because people realise that debts will become harder to repay in the future as their incomes fall so they pay them off as soon as possible, and people who are inclined to spend delay because they know that prices are dropping so they will pay less the longer the delay. The effect of these factors, as well as general saving and cutting back, takes yet more money out of circulation, more people lose their jobs, and wealth production is reduced even further. The natural result of this process in the absence of a welfare state or charity is an economy cut back to the barest essentials and many people in dire poverty, many others having already starved to death. A welfare state and/or charity raises the floor for the end of the process, but even with these in place the result is a situation where many fewer people are employed, many fewer goods and services are produced, and overall the wealth production in the economy has dropped substantially. This is a depression, and it is indeed a very apt name, because the all-pervading mood in these circumstances is one of severe depression.
There is a secondary effect that should be mentioned that serves to dampen the downward spiral to some extent, which is that as people become worse off they are forced to spend a higher proportion of their income, so spending drops at a lower rate for each successive pass round the loop. This is a positive effect but not one that can prevent the damage, because spending is still dropping, and it is that which is harmful to people and to the economy.
The shortfall in wealth production from that at full employment is known as spare capacity - where there are people and unused machines available for work and work that can be done, but because of lack of money they can't get together. The reason is that potential employers won't hire people for fear that the goods they produce won't be sold, and they are right because people don't have sufficient money or willingness to buy the goods that could be produced. It is only the availability of money that has changed, and money is only symbolic, but nevertheless real people are harmed and real lives are blighted. Recall the point emphasised earlier about everyone having within themselves a wealth-creating engine where it can only be started by another. This is where the irony that it encapsulates is felt with real pain.
When an economy with sufficient money for full employment experiences a reduction in spending, less wealth is produced, unemployment rises, spare capacity builds up, and prices and some wages fall, especially in industries producing non-essentials.
What has happened is that the economy has shrunk. The view of neoclassical economics (pre-Keynes) was that the wage rate brought supply and demand for labour into balance, so that when unemployment rose the real wage[77] should drop to make employing people more attractive to employers and thereby bring back full employment. The theory was that money wages should fall, but prices should stay the same and therefore profits should rise. This sounded quite reasonable and for a single firm or group of firms this is indeed what happens, but it neglected the fact - explained by Keynes in his General Theory (Keynes 1936) - that for the economy as a whole earners are also spenders, and when people earn less they have less money to spend, so there are fewer buyers that can afford existing prices so demand is lower and that causes prices to drop and profits to fall back again, thereby bringing the share of proceeds going to workers and the real wage rate back up to a large extent. This is examined further in chapter 35. It is another paradox - the real-wage paradox - caused by regarding the economy as a whole as behaving in a similar manner to a single participant in the economy, in this case a single firm.
Nevertheless if all wages and all prices dropped in the same proportion at the same time then nothing need change; the economy could continue as before but with all the same transactions being undertaken with less money. In fact this is what happens when a country's currency falls in value. All domestic prices and wages fall together relative to foreign currencies, but since things are bought and sold in the domestic currency the effect isn't very evident so things go on much as before, albeit with some domestic prices increasing when influenced by dearer imports. Economists who think that all wages and prices should drop in the same proportion when spending drops blame trades unions for resisting wage cuts, and blame the welfare state and charities for preventing workers from being forced to accept wage cuts. The problem is that in order to transform an 'in principle' theory into a real-world effect there has to be a mechanism that can perform that transformation, and in a society where people have freedom of choice there isn't one. In the real world a loss of money in an economy cannot possibly cause all prices and all wages to fall at the same rate because when people are short of money they dispense with those products that provide the least benefit to them, which are generally the less essential products, and those products suffer the greatest drop in demand and hence price, whereas the more essential products retain their demand and their prices don't fall. Therefore when people have less money to spend prices (and some associated wages) necessarily fall at different rates.
This reflects the difference between money as used by individuals and families, and by the economy as a whole - the paradox of thrift. For an individual or family money comes into their hands from wages, benefits, savings interest and so on, and goes out of their hands when spent. In effect it is used up in the normal course of life and has to be replenished at regular intervals. In these circumstances thrift is a virtue. However for a whole economy it is completely different, and many people, including many politicians[78] don't realise this. Within an economy money is not used up, it just changes hands and keeps on circulating. The vital difference between an individual or family and the whole economy is that in the economy one person's spending is another person's income, and when people cut back on spending for whatever reason in significant numbers then workers lose their incomes because without spending producers cut back or stop production.
Wealth creation (known as supply side economics) is generally the main focus of attention in neoliberalism, but sale of wealth (demand side economics) is every bit as important because it provides the destination for created wealth, and without a destination wealth creation soon stops - a company that can't sell its products soon stops producing them.
It is of the utmost importance to recognise that the economic engine - wealth being created by people and machines working; people being paid wages; wages being spent on wealth - can never be allowed to stop, because people need to consume a continuous supply of wealth in order to live. At the most basic level they require survival needs to stay alive, and at slightly more prosperous levels they require self-respect needs to live with dignity. Beyond that there are things that make their lives more secure and comfortable, and after that more enjoyable and luxurious - these are the least necessary and as already argued excesses are unjustifiable when there are people without basics and unmet social needs. For all these things capital as well as consumer wealth is needed. The wealth-creating loop of creation and use must continue and anything that slows it down means that there is less wealth available for people to use. Creation and use needn't be simultaneous of course and seldom are. Indeed much wealth (including capital wealth) is created now for use in the future, but when the future comes and that wealth is used yet more wealth will (hopefully) be in course of creation at that time for a later future. Overall, in any time period, in a well-functioning economy, wealth that is created will be balanced by wealth that is used, although the wealth used in a particular period need not be the same wealth as that which is created in the same period.
In order for the economy to function properly wealth must be traded and used at the same rate at which it is created.