Does America Need a Recession? Of Course Not...

Does America need a recession? I say no, but The Economist has other ideas:

Does America need a recession?, The Economist: ...When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. ... Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it?

Most people think the question smacks of madness. ...

But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows? ...

The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. ...

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses ... is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

This does not mean that the Fed should follow the advice of Andrew Mellon, the treasury secretary, after the 1929 crash: “liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate...It will purge the rottenness out of the system.” America's output fell by 30% as the Fed sat on its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's chairman, will not make that mistake. Central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether.

Of course, even if a recession were in America's long-term economic interest, it would be political suicide. A central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic economists asking whether a recession once in a while might actually be a good thing.

So let's talk undiplomatically about this:

1. I disagree that we need recessions to have a dynamic economy. Equilibrium means (in simple terms) "no tendency for change" and there is nothing inconsistent with having a constant flow of entering and exiting firms at equilibrium.

When profits are high - as in the traditional price signaling story - there is a rush to enter industries, but the trick is to get there first and take some of the profits before others beat you to it, innovation and technological change are not so important. There are lots of profits to be had by entering with existing technology so, while it does allow the installation of the best and latest technology, there's no strong pressure to innovate. In fact waiting until there is an innovation could be costly.

It's when conditions are tight, i.e. when everyone is making close to zero economic profit, that new cost saving or demand enhancing technological change will pay off. If you have a better product or lower costs than rivals, then you will gain an edge and realize profits. The only way to get ahead is to build a better mousetrap. Sure, conditions will be tight in recessions - that's the traditional creative destruction story - but things are tight in a competitive equilibrium too and the pressure to innovate does not disappear just because the economy is operating at full employment.

So I don't see why a full-employment equilibrium cannot also be a dynamic economy. That is, suppose there is an industry with 1,000 firms in it all doing about the same thing (producing pizza), but every year (at a continuous rate throughout the year), 100 go out of business and are replaced by 100 new firms with a cost advantage or better product (let's put cheese in the crust!). There is no recession here, a firm comes up with a better idea, enters (leading to temporary overemployment), and drives someone else out of business.

I am not an Austrian economist and I don't play one on the internet, so I won't claim to be able to recite what Schumpeter (or anyone else in the Austrian camp) said about this on a particular page of one of his books, so maybe someone who is an adherent to this "we need business cycles" approach can explain why we cannot wipe out the inefficient while remaining at or very near full-employment.

2. Overproducing houses is not like overproducing goods that cannot be stored, i.e. perishables. When too much popcorn is produced relative to demand, it goes to waste. Resources that could be used elsewhere are wasted forever since the excess can't be frozen or stored for the future (or at least assume so for the purposes of illustration, there is that stuff in movie theaters). With houses, there is an intertemporal shift in resource use, but since houses don't spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in underproduction tomorrow. The houses were built too soon, and that's an efficiency loss because we gave something up, but when we produce less houses later we can recover (some of) the goods that were lost (too many houses and too few cars in year one, but in year two it's the opposite, too few houses and too many cars relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage means we didn't have the opportunity to produce less later, so there is no way to make up for it, even in part, later on.

That is to say, I hope we don't "creatively destroy" the houses that were (over)built. Sure, some can be creatively transformed into restaurants, business offices, etc., to attenuate the misallocation in the short-run, but there's no need to tear them down and replace them. With time, population and demand will grow, and the houses will be filled. Hula hoop factories needed to be creatively destroyed, they needed to be torn down and replaced - it's unlikely demand will return in the future so having those factories around would be a waste, they would never be re-opened - but houses are not hula hoops. With houses, there is no need to "purge the excesses of the previous boom," just wait for population to catch up (and would it be so bad to have low cost housing available in the interim?).

3. I don't understand the reasoning that says the Fed should not stabilize the economy because it will "create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession."

The reasoning is that if we stabilize the economy, people will then believe recessions are impossible (or underestimate their likelihood) and make bad decisions, so we shouldn't stabilize at all.

People who believe the Fed can prevent all economic fluctuations will be, so to speak, "creatively destructed" the first time there is a recession. But to refuse to stabilize the economy to the best of our ability because we are afraid people might misperceive the degree of stability that is attained seems misguided to me. I would have thought an Austrian response would be to do what's best for the economy and let those who misperceive be weeded out by the market process (or better yet, that they become informed about the true risks - this is a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the information, not to refuse to stabilize).