Ratchet Effect

Ratchet effect is an economic phenomenon when a process continues indefinitely and has difficulty reversing its direction. The effect is based on the mechanics of a ratchet or a cog, which rotates smoothly in one direction, but finds trouble turning in the opposite direction.

The need to constantly move in a particular direction resembles human behavior. Hence, the ratchet effect extends to politics, economics, business, consumption, etc. Therefore, studying this effect can help governments monitor and control the economy. However, reversing such an effect can be challenging, requires force, and can have counter-productive results. 

• The ratchet effect is a macroeconomic concept in which a process happens in a particular way continuously that it would be extremely difficult to reverse the direction.
• To reverse the process would be a hectic task, requiring incredible force. Also, once changed, the process could produce disruptive results.
• The ratchet effect in economics can be seen in various circumstances because of its resemblance to the human tendency to move in a single direction uninterruptedly. Especially, the effect can be seen more distinctly in public consumption patterns.

Ratchet effect in economics was first introduced by Peacock and Wiseman in 1961 when they studied the public spending trends after times of crisis. However, the effect has grown beyond that as we can see it in many economic components. 

First, let’s try to understand the mechanics of a ratchet and its similarities to psychology, as its effect on economics is prominent because of human behavior. 

A ratchet is a mechanical wheel or a cog that rotates in a particular direction when powered by energy. It does so continuously and tends to keep rotating in that direction. Therefore, one would require more energy to turn the ratchet in the opposite direction. It would be complex and, based on the size and power required, reversing it could even produce sparks. 

Now, consider a person who drives north of a straight road forever. He wouldn’t be ready to turn directions and certainly not take a U-turn, as he isn’t prepared to do so. Therefore, turning would be extremely demanding for him, and he might even end up getting dents or scratches in his car. Similarly, this psychology applies to an economy too.

The ratchet effect in consumption is one such example. Suppose people are spending too much money on goods and services. Over time, this would lead to high inflation. But those who were spending continuously would find it difficult to hit a break and stop making purchases or even reduce it. However, the government will try to increase the interest rates on borrowing to decrease consumption.

If the government reverses the consumption pattern, the money supply in the economy would eventually decrease, which is another macroeconomic issue. It might reduce business profits and lead to salary cuts and unemployment. These are the sparks of reversing the direction of the ratchet.

Let’s discuss the ratchet effects of the COVID-19 pandemic. According to a paper published by the American Institute for Economic Research, during times of crisis, the government gets excessive authority, sometimes even higher budget for the welfare of the people. But even after the crisis ends, the control remains with the government. It does not come back to its original level. 

There have been many such situations in the United States. Firstly, there was the extension on repayment of student loans six times since the pandemic began. Secondly, the government prevented landlords from evicting tenants who had been unable to pay their rents owing to their financial distress during the pandemic. Again, it was done five times until the Supreme Court decided to intervene. 

Like this, the U.S government passed a total of 153 orders in view of the pandemic. However, the U.S. is not the only such example. During any crisis, governments have the power to suspend certain activities. But even as everything returns to normal, the government continues its function with the additionally designated authority.

Let’s briefly look at the diverse areas resembling the ratchet effect in an economy:

1. Government: As mentioned in the example of the United States above, additional power is conferred to the government at times of economic distress as the situation warrants, and it stays with the government forever.
2. Business: A company that handles billion-dollar operations will find it difficult to scale down, despite any circumstance.
3. Investors: The shareholders in a company can relate with the leverage ratchet effect, where they resist any reductions in leverage, even if it might make profits in the long run.
4. Customers: It is best when markets operate according to supply and demand. When the supply of a product that has been in high demand for a long time falls suddenly, customers find it difficult to manage their requirements.
5. Employees: The ratchet effect is relevant here too. Employees usually resist increasing working hours and decreasing minimum wages, which can disrupt their tendency to move towards better work-life balance and working conditions.

This article is a guide to what is Ratchet Effect & its definition. Here we explain ratchet effect in economics, its applications along with an example. You may also have a look at the following articles –

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