Monday, January 7, 2008

Another Look at The Cleansing Effects of Recessions

There have been rumblings in the blogosphere and elsewhere that a recession may be needed to purge out economic imbalances in the U.S. economy (see my postings here and here on this idea). Yoonsoo Lee and Toshihiko Mukoyama have an article that helps shed light on this discussion:
Yoonsoo Lee, Toshihiko Mukoyama, 8 January 2008
It is commonly believed that business cycles ‘cleanse’ industry with waves of creative destruction. New research shows that entry is higher in booms than busts, but exit rates and the type of exiting firms, are steady over the cycle. Plants entering during recessions, however, are larger and more productive –‘creative entry’ rather than ‘creative destruction’.


  1. I haven't followed your posts very deeply, just a link level back, but my question is this... if there's something to be "corrected" why do it at once, with a recession, rather than over 5-10+ years? Is that even possible? Just pondering...

  2. Gabriel,

    Assume there was an economy-wide unsustainable investment boom that is coming to an end. There is now excess economic capacity and there are more people employed than are needed. Certain firms are no longer viable businesses and must close. Along with them, some workers will be fired. The boom is over and the correction is underway. Could this outcome be avoided by spreading out the adjustment over 5-10 years? The only way I can think for this to happen is for some government-induced positive aggregate demand shock. This, however, should only postpone judgement day if my initial assumption is true: the boom was unsustainable from the start. Moreover, prolonging the needed correction may only lead to more imbalances building up and require an even more painful correction in the future. So I guess it gets down to the assumption of whether the boom was sustainable from the start.

    In the case of the potential housing-led U.S. recession, most indicators show the housing boom was unsustainable. Japan had a similar asset bubble burst in the late 1980s and had various forms of government bail outs throughout the 1990s. All they got was stagflation. Japan avoided a deep recession, but got a prolonged malaise in their economy. I would also mention Paul Volker, the Fed chairman before Greenspan. He and his pals at the Fed induced a major double-dip recession in the early 1980s. Today, they are given credit for being bold and making right but painful choices.

    This is not to say government should stand by and let a ‘cleansing recession’ turn into something more dangerous. Many economists believe bad policy—or the absence of good policy—allowed what would have been an otherwise normal recession turn into the U.S. Great Depression in the 1930s.

    My belief for now is that a correction is needed for the U.S. economy. (Of course, the article I link to above says that firms exiting during recessions are not that different than during booms. Even if firms don’t exist employment is procyclical and labor adjustment are made. Also, the study is based on manufacturing firms alone.)

  3. Seems like this evidence, and your arguments earlier, point up the deficiency of leading macro models. Both trad Keynesian IS/LM/AD/AS and RBC/NKE models are all single sector. Your arguments would suggest 2-sector macro models are needed at a minimum to handle the mis-allocation of resources you believe causes business cycles. A consequence would be that policy advice based on current textbook models is not that well theoretically-grounded?