Monday, July 13, 2009

How Recessions Can Be Good

Are there any positive benefits of a recession? That is the question that Christopher Hayes explores in an article in The American Prospect. The argument that some economists have proposed is that a depression can clear out inefficient firms, similar to a forest fire that clears out the undergrowth, resulting in a stronger economy in the long-term. See the following post from Economist's View, that discusses this idea.

Chris Hayes takes up a notion I've never been very fond of, that recessions are necessary and healthy since they clear out inefficient firms, and spur the development of new innovation during the recovery phase. (Why do I think this is unnecessary? The entry and exit of firms driven by innovation and the development of new products can be part of a full employment equilibrium, that is, cycles are not needed to clear out old firms and spur innovation. Imagine an economy where a new idea allows a slightly more productive firm to enter a market and displace a less productive firm, and the workers migrate from the old to the new firm over time. If this happens at a constant rate in aggregate over time, there won't be any cycles at all, but we still manage to clear out the inefficient firms and replace them with more innovative rivals. The displaced workers from the the innovation driven structural adjustment are part of the natural rate of unemployment in such an economy):
Are Depressions Necessary?, by Christopher Hayes, The American Prospect: ...Are economic contractions, like the one we're currently experiencing, a good thing? ... It would be career suicide for any elected official to suggest that the widespread stress, misery and heartache being wreaked by ... contraction were are a good thing. But scratch the surface a bit and you'll find a surprisingly vibrant school of thought, one that reaches back all the way back to the Great Depression, that holds precisely this view.

Famed economist Joseph Schumpeter said that "a depression is for capitalism like a good, cold douche," one that rinses off accumulated dysfunction. Robber baron Andrew Mellon (who served as Herbert Hoover's treasury secretary) welcomed the Great Depression with these infamous words: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people"

It's not hard to find this same view among bankers, financiers and sundry Wall Streeters today. ...

The stakes for this argument are very high: if steep economic contractions are like forest fires, a necessary part of the system's self-calibration, we should more or less let them burn. If they are more like five-alarms raging through dense city neighborhoods, we should call in the fire department.

Newsweek and Washington Post columnist Robert Samuelson is perhaps the most prominent and outspoken Mellonist writing today...

Paul Krugman, to put it mildly, disagrees. ... What animated much of this advice was not just a rigid and dogmatic economic consensus, but also the puritanical normative assessment that a wicked economy must now pay its penance. (Of course said penance was never paid by those who caused the crisis: It was paid out of the pockets of the starving, the poor and working class.)

It's exactly this notion that Krugman seeks, above all, to dispel. ...

"...The ... business cycle may have little or nothing to do with your more fundamental economic strengths and weaknesses. [B]ad things ... can happen to good economies."

...More broadly, Krugman's point is that, contra Samuelson, recessions, and depressions and assorted downturns are not useful, cleansing opportunities to "purge the rottenness out of the system," but more often vicious cycles, auto-catalytic processes that result in massive amounts of human suffering, and waste human capital and an economy's productive capacity. More like the forest fire caused by a careless camper than the natural cleansings produced by mother nature.

The technical implication of this view for crisis management is that when an economy is stuck in a deep recession, like the one in which we are now mired, normal bromides of Chicago-style economics, those to which Samuelson clings so closely, cease to apply. ... Krugman ...[believes] deft and active management is necessary. Suffering is no badge or courage, but a sign of failure. ...

As Krugman persuasively argues, economies need management and policy to ... be saved from their own tendency to spiral into disaster, to cycle through booms and busts... Samuelson and those of the Mellonist school have an innate distrust of politics; meddlesome and vulgar and prone to demagoguery. Lately the political system as seemed to be working over-time to confirm their worst fears.

But ultimately there is not economics without politics, and as terrifying as this may be, economists can't save us from this crisis. Only politicians can.

This post has been republished from Mark Thoma's blog, Economist's View.
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