Increasing productivity by cleaning out low-productivity firms

In the Solow Growth Model, productivity is a powerful factor for raising income per person in a country. So it is important to maintain productivity growth if a country would like to have economic growth.

I have written recently that there are ways to discipline the market in order to achieve greater productivity and thus greater net social benefits. We could raise the minimum wage or raise the Fed rate. What would the result be? Low productivity firms get cleaned out leaving high productivity firms still in business.

There is a post at the Growth Economics Blog on this very issue. The post refers to a paper titled, Reallocation in the Great Recession: cleansing or not? The paper says that low productivity firms normally get cleaned out during a recession, which allows productivity to increase after a recession. But that didn’t happen after our recent crisis. So there is evidence that low-productivity firms are still in business.

So why didn’t low-productivity firms get cleaned out this time? As the Growth Economics Blog’s post says…

“The authors don’t offer an explanation, as their paper is just about documenting these changes.”

Well, some of the answers to this question are simple. If you keep real wages low, low-productivity firms have a better chance to survive.

prod real comp

This graph uses show real compensation (blue) and productivity (red). From the graph, we see that this is the only business cycle so far where real compensation has not risen. You can also see a correlation between productivity and real compensation. By the way, productivity rose greatly back in the 50’s and 60’s, and look how steadily real compensation grew through the recessions back then.

Then we can look at the Fed rate.

fed rate fred

This is the only business cycle where the Fed rate has not risen to challenge low-productivity firms. Productivity has a delayed response to an increase in the Fed rate due to a subsequent process of cleaning out low-productivity firms, usually in a recession.

One would think that if the Fed rate was truly tight for market conditions, we would have seen more low-productivity firms get cleaned out. But the continued existence of relatively more low-productivity firms supports the view that the Fed rate has not been tight and therefore not disciplining low-productivity firms.

Also the banks want low-productivity firms to stay alive because the banks are protecting their own capital ratios.

So these two processes of challenging low-productivity firms, higher real wages and a rising Fed rate, have been excessively weak so far in this business cycle. The result is a weaker economy.