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

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





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

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.
</blockquote>
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).