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Are recessions good for us?

Created:

2 September 2008

Written by:

Chris Dillow

What effect do recessions have upon long-run growth? This is usually an abstruse academic question. But it matters for investors now. If recessions are good for long-term growth, as some economists believe, then the price-earnings ratio on the market should now be above average (other things being equal) because we can look forward to better-than-average growth. The fact that it's now low might, therefore, mean that shares are cheap.

So, why should we think recessions are good for us, in the long run?

Natural selection

Simple. Recessions kill inefficient firms. That allows more efficient ones to grow faster as they can hire workers laid off by their bumbling rivals, or buy up the plant and property others are forced to sell off. In this way, recessions are like lawn weedkiller. In destroying weeds, this gives grass the room and nutrients to grow better.

The classic exposition of this view came from the Austrian economist Joseph Schumpeter. Recessions, he said, "are the means to reconstruct the economic system on a more efficient plan." They "clear the ground" for future growth. Although this view fell into disrepute as a result of the Great Depression of the 1930s, Brad De Long of the University of California at Berkeley has shown that it might have been true of most recessions in American history.

Time and space

There's a different way in which recessions might raise productivity growth - they give bosses the time and incentive to restructure their businesses.

In booms, companies are too busy just meeting demand to think about improving efficiency. And they don't want to introduce new technology or change working practices because the temporary disruption these changes might cause could lose them business. But in recessions - when they are working less frantically - the costs of such disruption are lower; firms can afford to risk teething trouble with new software, and can afford to send people on training courses. Gilles Saint-Paul, an economist at the University of Social Sciences in Toulouse, has gathered some evidence to suggest these mechanisms are important, and that temporary falls in demand can help to raise long-term growth.

Asset legacies

There's a third view which doesn't so much say that recessions are good things, but rather that they do less harm than the preceding booms do good, with the result that it's better to have booms and slumps than steady growth.

Daniel Gross expressed this in his recent book, Pop! Booms, he said, leave behind valuable infrastructure: railways, broadband cable or houses. These real assets don't get destroyed in recession.

Keith Blackburn, a professor at the University of Manchester, adds another reason. A lot of productivity growth, he says, comes from learning by doing. In booms, there's a lot of doing and so a lot of learning. But this knowledge doesn't get forgotten in a recession. So the net effect of boom and recession upon productivity growth is positive.

If all this is right, we should stop worrying about recession because it is, in the long run, good for us. Sure, in the near-term people will lose their jobs and businesses. But these are prices we must pay for the creative destruction that drives economic growth - and, in principle, such costs are insurable.

Sadly, though, it might not be right. There's some strong evidence against this optimistic view.

Some of it comes from Paul Gregg's and Paul Geroski's study of the last recession, in 1990-91. They found that it was "very hard" to predict which firms would suffer in recession. In particular, firms with low profitability before the recession were no more likely to be badly hit than more profitable ones. This suggests recessions don't necessarily weed out inefficient firms, at least if we measure efficiency by profitability. Efficient ones can suffer too.

Further evidence on this comes from Yoonsoo Lee and Toshihiko Mukoyama, two US academics. They've found that the probability of plants shutting doesn't vary much between good times and recessions, suggesting recessions don't kill inefficient firms any more than normal.

But even if recessions do kill economic weeds, it doesn't follow that healthy plants will take advantage of this and grow, because efficient firms don't necessarily grow faster than less efficient ones. "Productivity levels are not very helpful in predicting firm growth rates," says Alex Coad of the Max Planck Institute. "Growth is a random process."

If you think this is odd, you've forgotten one of Adam Smith's famous sayings: "the division of labour is limited by the extent of the market". Some quite efficient firms, such as those making niche products, can't expand simply because there isn't the market for their goods even in normal times. Firms grow not because they are efficient, but because they can. It's survival of the fittest, remember - and even this much is doubtful - not growth of the fittest.

So, the evidence that recessions are good for us is mixed. But we've only considered aggregate growth. What really matters for shareholders, though, is the growth prospects of existing, quoted companies; it's no use to us if small, private firms grow fast. And it's possible that recessions are good for existing firms.

Messrs Lee and Mukoyama found that recessions tend to stop new firms entering markets - although the ones that do so are especially competitive. Which suggests that recessions might increase the monopoly power of incumbent firms. This would be especially true if recessions - or at least this one - tighten the availability of credit to new, growing firms.

So, it's possible that recession, even if it's not good for the economy generally in the long run, might be good for the profits of incumbent quoted firms. And this in turn suggests that low price-earnings ratios on the market generally might be a sign not of poor growth prospects, but of high risk. And high risk should mean high expected returns.

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