Costs of recession

The Resolution Foundation’s James Smith has written a nice paper on the likelihood of recession and the fact that, with monetary less able to support the economy, we need to think about alternative ways of tackling recessions. I just want to amplify what he says in two ways.

First, there’s increasing evidence that recessions can do long-term damage, even if the economy appears to bounce back in the short-term. There are at least three mechanisms here:

 - Education. Bryan Stuart shows that the 1980-82 recession in the US “generated sizable long-run reductions in education and income.” Parents who suffer a drop in income spend less on children’s books and educational trips, and this makes them less likely to go to college a few years later. Such effects are magnified if bad macro policy causes restraints upon public spending on schools and libraries.

 - Productivity. Recessions increase uncertainty, which depresses investment in both capital and R&D, leading to lower productivity growth. The Bank of England’s Dario Bonciani and Joonseok Jason Oh say:

Shocks increasing macroeconomic uncertainty can lead to very persistent negative effects on economic activity that last well beyond the business cycle frequency. 

 - Scarring. A recent paper by Erin McGuire shows that people who grow up in hard times “invest less in risky assets throughout their lives, invest more in property, and are less likely to be self-employed.” This corroborates research (pdf) by Ulrike Malmendier and Stefan Nagel. Through this channel, recessions can reduce entrepreneurship and increase the cost of capital even decades later.

Against all this, it is theoretically possible that recessions have a beneficial “cleansing” (pdf) effect: in driving inefficient firms out of business, they make it easier for more efficient ones to expand, and this raises productivity growth.

One Big Fact tells us that effect hasn’t operated recently: productivity has flatlined since 2008. One reason for this is that financial crises can hamper the expansion of even the best firms, in part by causing them to fear for the future availability of credit.

All this evidence makes me believe that recessions are more costly than I (and I suspect others) previously thought. Policy-makers should, therefore, do more to prevent or mitigate them.

Which brings me to my second amplification of James’ paper. “We can’t recession-proof the economy” he says. He’s right. We cannot prevent recessions by seeing them in advance and relaxing monetary or fiscal policy, simply because recessions are unpredictable. Back in 2000 Prakash Loungani wrote that “the record of failure to predict recessions is virtually unblemished”, a fact that remains true today. The Bank of England did not cut Bank rate to 0.5 per cent until March 2009, a full year after the recession began.

For me, this requires alternative policies. Some should aim at reducing the risk of recession, for example by ensuring that banks are so well capitalized that losses needn’t lead to cuts in lending. Others should aim at moderating recessions via strong automatic stabilizers, such as progressive taxation and a strong welfare state – and perhaps a job guarantee. 

Yes, such changes might reduce the benefits of the cleansing effects of recession. I suspect, though, that such  productivity-enhancing gains could be achieved at much lesser cost by policies to increase product market competition.  

Of course, recessions are an inevitable aspect of capitalism. With their costs now greater than previously thought, it is all the more important to mitigate them, which requires not just macro policy but also institutional change.

Comments

[Zen]

All true no doubt.

But I cannot help feel we are reinventing the wheel.

In the bad old days of high Keynesian policy it was universally accepted that recession and under employment were great evils and demand should be kept permanently high. Real wealth is what matters not nominal value and high employment was a social duty as the least fortunate suffer most from the instability of capitalism. Then came along Ronnie ray gun and Thatcher and all that was dumped for an obsession with prices and nominal value and speculation in land. Drive up unemployment to crush the unions, cut taxes for the well off and trash the welfare state in stages. Austerity being the latest instalment.

An economist In 1975 as Prof. Krugman has observed, looking ahead, would have regarded economic policy since 1980 as the work of cranks if they had foreknowledge of things to come. By a series of radical innovations policy has moved from what you would expect in a democracy to what you would expect in a oligarchic arrangement where the asset values of a tiny elite determine the whole of economic policy. Before 1980 the political class actually cared and tried very hard to deliver, now they are indifferent and lazy. We do not need papers by economists to observe it.

[Ander Broadman]

Brilliant use of the Jarrow picture.

[nicholas ford]

I suggest that Chris's point about bank capital highlights a weakness in existing institutional arrangements.
The Bank of England lacks a vital power. To prevent or mitigate recessions, it needs to be able to instruct specific banks to raise more capital by issuing equity. That is how it must prevent bank lending from collapsing if a portion of banks capital is wiped out by bad loans. The existing power - causing banks to maintain high capital ratios - would actually cause recession if banks lost a significant amount of capital due to bad loans.

[georgesdelatour]

“Of course, recessions are an inevitable aspect of capitalism.”

Not just capitalism. Rome’s “Crisis of the Third Century” was, among other things, an extended recession. The 15th Century “Great Slump” in England was a 40-year-long recession which lead to Jack Cade’s rebellion. I’m no expert, but I wouldn’t be surprised if hunter gatherer societies sometimes undergo recessions.

[Steven Clarke]

@Chris

Off-topic, but the 'Blair reconsidered' link it TOP BLOGGING links to the 'Takers and Makers' article.

I'd quite like to read it

[Mr Peach]

You make some interesting points Nicholas. No doubt there are gaps in the institutional framework. George Stein once argued that banks' capital requirements should be set in absolute terms instead of as ratios to avoid painful reductions in the credit supply.

However the Basel framework explicitly deals with pro-cyclicality in the supply of credit. Firms have capital buffers that can absorb shocks, but they have to be rebuilt over time. This means that losses can be absorbed without balance sheet contraction, and then firms can rebuild buffers over time using a mixed strategy (e.g. changes in the size of the balance sheet, retained earnings, remuneration, reducing the cost base or issuance) If losses exceed buffers then I agree. We'd be in a scary place!

But I doubt your proposal would remedy those problems. Could a bank really issue capital if its solvency was in question? I personally doubt it. The only option then would be bail-in, recapitalisation or allowing a bank to fail.

[Mr Peach]

Typo - I meant Jeremy Stein.

[reason]

I've always felt that the idea that recessions could be beneficial "in driving inefficient firms out of business" is dubious, because being driven out of business is not particularly a function of efficiency. A depressed economy is a different economy than a thriving one. In a thriving economy, wages, rents and raw material costs will be rising and this should drive inefficient firms to the wall just as surely as a fall in demand.

[reason]

I just realized it could be even worse than I outlined above - it could be that precisely the inefficient firms are the firms that will survive the downturn.

If by efficiency you mean lower marginal cost, and marginal cost has been lowered by increasing fixed cost and reducing variable cost, then a fall in demand will hit the efficient producers harder.

[Matthew Opitz]

"Not just capitalism. Rome’s “Crisis of the Third Century” was, among other things, an extended recession. The 15th Century “Great Slump” in England was a 40-year-long recession which lead to Jack Cade’s rebellion. I’m no expert, but I wouldn’t be surprised if hunter gatherer societies sometimes undergo recessions."

The difference I see is that all of these recessions must have surely been "crises of underproduction" whereas recessions under capitalism are "crises of overproduction." In other words, I would be mightily surprised if a recession in a hunter-gatherer society took the form of idle, fruitful berry bushes and hungry, yet idle berry-pickers sitting around side-by-side for lack of monetary demand to mobilize each factor of production. This is what makes capitalist recessions particularly maddening. They are, with a few exceptions, not caused by crop failures or other "Acts of God" that forcibly limit physical output. Instead, physical output remains higher than ever, and in fact does not even get used to its full potential, and still much of it goes to waste in a recession because there is lack of monetary demand for it.

I would also question whether "automatic stabilizers" can really mitigate capitalist recessions like the original author suspects, for the reasons explained in the Critique of Crisis Theory blog posts entitled "Are Marx and Keynes Compatible? Pt 4" and "Pt 5" (I will not post a link in order to ensure my comment does not get spam-filtered, but the reader should be able to find the articles easily enough).