Monday, February 11, 2008

Can a Recession Really be a Good Thing?

It is argued by some people that a recession can benefit the economy, at least in the long run. The reasoning is that falling revenues force firms to become more efficient, e.g. cutting unnecessary costs e.t.c. In a recession, inefficient firms will go out of business and this shake up is necessary to weed out the inefficient and provide incentives for firms to be as profitable as possible.

This belief was articulated by the Chairman of Ryanair, Michael O'Leary's recently, arguing that a recession would be a good thing. see Guardian article

However, is this a good argument?

Problems of Recession - Why A Recession is Bad

  1. A recession will make it difficult for new firms who have just entered the market. Most new firms have high set up costs, therefore, a downturn in the economy could make them close down. However, this does not mean that they are inefficient. It just means they are new and struggling to get established..
  2. Increased Monopoly Power. If a recession causes the smaller and newer firms to go out of business then the larger dominant firms will gain more monopoly power. In the long run this will lead to less choice and higher prices. This is a definite disadvantage of a recession. When the Chairman of Ryanair argued recessions would be a good thing, maybe he meant - a good thing for Ryanair, as it may involve new firms going out of business leaving him more market power.
  3. Hysteresis. This is the argument that the past is a predictor for the future. Basically, if you have high unemployment, then it is more likely to have high unemployment in the future. If people are made unemployed in a recession, it may take a long time for them to find work again. When they are unemployed they lose skills, become demotivated and become less attractive to employers. Note after the recession of 1981, Unemployment remained stubbornly high in the UK, even into the boom years of the late 1980s
  4. Fall in Productive Capacity. A recession can damage the productive capacity of an economy. Firms can go out of business and therefore shut down their resources. Furthermore in a recession, there will be a significant fall in investment, this can harm the long term development of an economy.
  5. You don't need a recession to weed out inefficient firms. If markets are reasonably competitive, inefficient firms will be forced out of the market anyway.

A recession is unnecessary to increase economic efficiency. The long term future of an economy can be best helped through stable growth, which avoids the extremes of boom and bust economic cycles.

Definition of Recession

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