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SURVEY:
THE WORLD ECONOMY

A necessary
evil

Sep 26th 2002
From The Economist print
edition

Should we learn to love
recessions?

WHEN America's
bubble burst last year, the Fed swiftly cut interest rates. This has
become a habit: every time there has been any financial turmoil at home or
abroad—such as the crises in East Asia and Russia and the near-collapse of
Long Term Capital Management in 1998—the Fed has pumped more money into
the economy. Low interest rates have saved America from a deep recession.
But after such a binge, might the economy not benefit from a cold
shower?

Most people would
consider this a heretical question. They assume that it is a central
bank's job to avoid recessions at all cost. According to one survey,
four-fifths of Americans believe that preventing recessions is as
important as preventing drug abuse. But are recessions always an
unmitigated disaster, or do they also offer some economic benefits? And if
central banks respond to every danger sign by pumping in more money, does
this not risk simply transferring the problem elsewhere? As America's
stockmarket bubble has burst, another bubble now seems to be inflating in
its housing market. This allows consumers to go on partying, but what
happens when the drink runs out?

According to the
Austrian economic paradigm described in the second section of this survey,
recessions are a natural feature of an economy. Joseph Schumpeter argued
that recessions are not an evil that should be avoided, but a necessary
adjustment to change. Only by allowing the “winds of creative destruction”
to blow freely could capital be released from dying firms to new sectors
of the economy, thereby boosting future productivity.

Hayek counselled
against massive monetary easing to prevent a recession. If unprofitable
investments were made during a boom, then it was better to shut those
firms down and clear the way for new, more productive investment. For the
Austrian economists the policy choice is not between recession or no
recession, but between one now or an even nastier one later. A recession
is necessary to work off an imbalance between too much investment and too
little saving.

Keynes, quite
reasonably, ridiculed the idea that in the long run the Great Depression
might turn out to have been a good thing. In the early 1930s the Fed and
the American Treasury did not pursue expansionary policies, precisely
because they thought these might hinder the necessary adjustment. Andrew
Mellon, the secretary of the Treasury, urged the market to “liquidate
labour, liquidate stocks, liquidate the farmers, and liquidate real
estate...It will purge the rottenness out of the system.” America's output
duly fell by 30% as the Fed sat on its hands.

Today, a slump on
that scale would be unlikely even if the Fed had not cut interest rates
swiftly. It would have been headed off by a variety of changes made since
the Great Depression: higher government spending and hence more powerful
automatic fiscal stabilisers; bank deposit insurance; and a stronger
commitment by the Fed to its role of lender of last resort. But even the
Austrian economists themselves came to reject the idea that faced with a
potentially severe recession, policymakers should do nothing. They
approved of stimulus measures to stop recessions from turning into deep
depressions, but not of preventing recessions altogether.

The case for the
defence

Why is economic
instability always assumed to be bad? Some economists argue that
recessions result in a permanent loss of output. This rests on the notion
that there is a fixed ceiling for output, rising over time, so any
shortfall against potential is a permanent loss. On this view,
demand-management policies can fill in the troughs without shaving off the
peaks, thus increasing average growth.

A more realistic
way of looking at it, however, is that business cycles are fluctuations in
output above and below an equilibrium trend. This suggests that
demand-management policies can mitigate recessions only to the extent that
they also choke off expansions; they cannot increase the average rate of
growth or employment. Admittedly, cyclical increases in unemployment may
become permanent if labour-market rigidities, such as strict
hiring-and-firing laws, make it hard for the jobless to find work even
when the economy recovers, a condition known as hysteresis. If this is
present, as it is in many European countries, then recessions can have a
permanent cost. But this is really an argument for labour-market reform to
minimise the cost of recessions, not one for measures to prevent them
altogether.

A second argument
against letting recessions rip is that households may value economic
stability for its own sake, even if it makes no difference to the average
unemployment rate. Justin Wolfers, an economist at Stanford University,
has used surveys of consumer satisfaction from several rich economies to
estimate the value that households place on stability. He reckons that
starting from current levels of volatility, eliminating the business cycle
would increase average well-being by the equivalent of a fall in the
unemployment rate of only 0.2 percentage points. By contrast,
labour-market reforms could reduce unemployment by several percentage
points.

A third common
claim is that economic instability and uncertainty may discourage
investment, thereby reducing long-term growth. Yet the evidence is weak.
More volatile economies do not appear to invest less as a share of GDP. Moreover, looking back, the 20 years to 1938 were by
far the most volatile in economic history, yet the average growth rate in
developed economies was 3.8%, well above the average growth of 2.7% during
the past two decades of relative stability. An analysis of 20 developed
economies since 1960 by Bill Martin of UBS Global
Asset Management finds little evidence that macroeconomic stability
promotes faster growth. If anything, he concludes, countries with greater
output variability have enjoyed slightly faster growth in productivity.

This is not as odd
as it sounds. A perfectly stable economy would miss out on the advantages
of booms as well as the alleged disadvantages of slumps. For instance, in
boom times, when credit flows freely, it is easier to finance the risky
innovations that may boost future productivity growth. Booms also
encourage mergers and acquisitions, a powerful tool for restructuring.
More important, as Schumpeter argued, recessions are a process of creative
destruction in which inefficient firms are weeded out, releasing resources
for more productive firms.

But can we be sure
that it will be the least productive firms that go bust in recessions, and
that they really will be replaced by new, more profitable ones? Awkwardly,
work by Ricardo Caballero and Mohamad Hammour, economists respectively at
MIT and DELTA, a French research
organisation, finds that good times may be more conducive to economic
restructuring than bad. The two economists examined gross job creation and
destruction in American manufacturing over the period 1972-93 and found
that at the onset of a recession job destruction increases, but it then
falls below normal levels until well into the recovery. Job creation
declines during a recession and remains relatively low during the initial
recovery. Adding up the net effect of job destruction and creation, Messrs
Caballero and Hammour conclude that the pace of restructuring actually
falls during a recession.

The figures on
which the study was based are available only for manufacturing, which has
a shrinking share of the economy. Once services are added in, the picture
might look different. Still, the study does raise the question of why
recessions might hinder rather than help industrial restructuring. One
answer is that credit markets are imperfect. When credit is tight in a
recession, even profitable firms can find it harder to raise money to
finance restructuring or new investment.

The dark side of the
boom

Even if recessions
are not always the most efficient way to reallocate resources, they are
necessary to purge the excesses of the previous boom. Stephen King at
HSBC argues that a recession should be seen as an
unpleasant cleansing experience which leaves the economy in a healthier
state: “A bit like taking a cold shower with a lump of carbolic soap.” But
America's economy has not yet completed this cleansing process: it still
has an inadequate savings rate, excessive debt and a huge current-account
deficit. The recent mild recession did little to correct these imbalances,
making further pain inevitable.

A good indication
of the size of the adjustment yet to be made is the private sector's
financial balance (or private-sector net saving, equivalent to saving
minus investment), a concept elaborated by Wynne Godley, an economist at
Cambridge University. In the United States the private-sector balance
shifted from a surplus of 5% of GDP in 1992 to a
deficit of 5% of GDP in 2000 as households and firms
went on a borrowing spree, an astonishing change after almost four decades
when the private sector never ran a deficit at all (see chart 8).

The corporate
sector's financial position was not wildly out of line with previous
periods of expansion: firms usually run a deficit during booms to finance
investment. It was the behaviour of the personal sector that was
exceptional, and remains so. The surge in share prices during the 1990s
encouraged households to save less and less.

In the past, when
a country's private-sector net saving has fallen so sharply, a deep
recession or a prolonged period of stagnation has usually followed. Events
in Japan, Britain and Sweden after their late 1980s booms are prime
examples. Mr Godley has long argued that the same outcome is inevitable in
the United States. But America's adjustment still has a long way to go.
The private sector's financial deficit has narrowed to 1.4% of GDP this year, but that still leaves it well below its
1960-95 average of a surplus of 3% of GDP.

So far, most of
the belt-tightening has come from firms, which have slashed their
investment and laid off workers. Consumers, on the other hand, have
continued to borrow, encouraged by easy money and rising house prices. But
the collapse in share prices is now likely to prompt households to save
more of their income. If the household saving rate rises back to its
long-term norm, at the very least a period of slow growth, and perhaps
another recession, will surely follow.

Was it a mistake
for the Fed to slash interest rates last year and thereby delay this
adjustment by households? Some economists believe that a deep but short
recession is preferable to a prolonged period of sluggish growth, because
recovery comes much sooner, with less damage to the economy's potential
growth rate. However, it is arguably better to unwind imbalances gradually
to avoid the risk of severe financial problems. Moreover, the Fed has been
worried that a deeper recession at a time when inflation is already so low
might lead to debt deflation, which central banks should avoid like the
plague.

Lower interest
rates have helped to prop up spending in America largely by fuelling a
credit-driven boom in house prices. This fixes one problem at the risk of
creating another. Rather than injecting more liquidity, would it not be
better if central banks tried to smooth the path of credit over the whole
business cycle?

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The
unfinished recession

Of
shocks and horrors

Defining
the R-word

Keeping
a lower profile

Weapons
of mass distraction

Crystal
balls-up

Japan's
lost decade

A
necessary evil

Bubble
and squeak

United
we fall

After
the bubbles

Sources
and acknowledgments

Offer
to readers

Websites

“The Cost of
Recessions Revisited: A Reverse-Liquidationist View” by Ricardo
Caballero and Mohamad Hammour.

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