Monday, 23 February 2009

Why are recessions bad?

Stephanie Flanders (and earlier, Tim Harford) raise an interesting question today. As they point out, changes in individual circumstances tend to dominate the macroeconomic aggregates - increases and decreases in individual income are usually much greater than the 3% increase or decrease in the output of the whole economy.

Of course, a 3% decline in GDP means that a few more incomes have fallen than risen - but on the face of it, this is a minor effect.

So what explanations could there be for the fact that we worry so much about recessions?

First, some of the effects are very visible. Lots of people lose their jobs - and a million more people out of work will always create some high-profile news stories.

Second and related, the media (and the public) select stories which confirm their overall narrative. Any newspaper whose main focus of the last two weeks was on the 9,000 new jobs at KFC rather than the 850 job losses at Mini would not look credible - its narrative would be out of step with what its readers expect.

Third, there are two possible statistical breakdowns of the overall effect - each of which has its own negatives.

The first possibility is a general slow decline in incomes - everyone loses about 2-3% of their income across the country. Due to loss aversion, people feel very strongly about a reduction in income. Thus a 2% decline is much more noticeable than the 2% increase we all had the previous year. The secondary psychological effect (the "hope" versus "fear" effect) strengthens this.

The other possibility (which Stephanie and Tim have indicated is the case this time round) is a big divergence in incomes. 48% of the country gets rich and 52% gets poor. In this case, due to declining marginal utility of income, the effect on the happiness of the people who get poorer is much greater than on those who get richer.

For all these reasons, a relatively small recession can have a much bigger impact on our overall wellbeing and satisfaction than the numbers would suggest.

2 comments:

Justeconomics said...

But recessions are also good!

1. Recessions are an important clean up phase for a developed economy.

It's during recessions that inefficiencies, frauds, and crimes in our financial system get discovered.

No one found the Enrons and the Madoffs during the boom time. When things are good, everyone looks the other way.

2. Recessions are how your boss gets fired.

When you do a bad job, your boss can fire you. But when your boss does a bad job who fires him/her? Recession.

During a recession, management teams that cannot meet the newly higher bar are dissolved through bankruptcy or restructuring.

Yes, this process is also painful for workers who contributed no fault, but this is the only way the market has to eliminate poor management. We can pay unemployment benefits to assuage the effects on the workers.

3. Recessions are how the economy can grow.

A developed economy like the United States grows through increases in productivity. During a recession, less productive companies will fail creating additional market space for more productive companies to take over.

As more productive practice become the norm, the economy grows.


To use a crude metaphor, a recession is like using the toilet. It may be smelly and uncomfortable, but if you don't do it, you won't be able to eat as much as you'd like to.

More at: http://competitivemarket.blogspot.com

Ravi said...

I am not sure how that is great analogy, its true recessions can have a very positive affect. An article on MSN detailed how many inovations came upon a recession in particular computers and electronics.

However, some countries don't really recover from recessions and depressions and improvements can vary.

America is so far positive in that aspect, it needs to learn and be competitive.