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On scarring effects

Recessions can do long-lasting damage to economies
On scarring effects

This recession might have nasty long-run effects. One mechanism here is that young people who are temporarily idle – even with decent income support – or who cannot get a decent job in the first place don’t get as much experience as their luckier peers and so suffer lower wages even years later.

Another mechanism, described in a series of papers by Ulrike Malmendier of the University of California at Berkeley, is that our economic behaviour is shaped not just by current realities and expectations, but by our memories. She shows that men who saw the 1930s Great Depression in their formative years borrowed less when they became chief executives years later, while younger men who were not so scarred were more adventurous. And, she shows, individuals who experienced bad times during their formation go on to save more, own fewer equities and be less likely to own their own homes even years later.

The 2008-09 crisis might well have had similar effects. Corporate cash holdings have almost doubled since then, despite nugatory returns on that cash. This reflects the fact that managers remember sudden falls in of demand and being unable to raise credit, and so have adopted more cautious policies towards managing their balance sheets.  

Napoleon was right: if you want to understand the man, you must know how the world appeared to him when he was 20. A whole cohort of people who see today’s frightening times could therefore behave in risk-averse ways in future years. This could depress economic growth over the long-run.

The effects are not all bad, though. For one thing, Professor Malmendier shows that people who save more because of memories of unemployment end up richer than they’d otherwise be.

Also, bad memories can improve the trade-off between unemployment and inflation years later. Memories of the Great Depression scared a generation of workers into accepting low wage rises in the 1950s, which meant that full employment did not cause inflation; it was only when the cohort that remembered the 30s retired, to be replaced by one that had only known good times, that wage militancy rose. Equally, perhaps memories of the 2008-09 recession have helped depress wage growth more recently. 

What’s more, we’ve no evidence that recessions reduce entrepreneurship in the longer-run. This could be because the scarring effect of them in reducing appetite for risk is offset by the fact that people unable to find employment start up their own businesses and so get experience of entrepreneurship they would otherwise not.

It would, however, be grossly irresponsible for any government to assume that these benign long-run effects will outweigh the adverse ones. Which provides us with another reason why Chancellor Rishi Sunak was right to follow the Danish government’s plan of paying the wages of workers threatened by layoffs.

I say all this as a counter to a common preconception. It’s often said that government debt is a burden on future generations. Perhaps it is – although it is a modest one when real interest rates are negative. But government borrowing isn’t the only way in which today’s events might damage people in future. The psychological scarring of traumatic recessions also does real harm – more, perhaps, than higher government debt.