Why do recessions occur?… One answer points to Productivity


Noah Smith made a thought-provoking statement on twitter, “Sometimes I wonder what actually causes recessions.” He received a slew of responses.

While one could point to many causes, including tight money and the beats of butterfly wings, I look primarily to the dynamics of productivity. Here is a graph of year-over-year productivity growth…

prod 34

You will see that productivity has a tendency to accelerate through the recessions. Productivity has a natural tendency to increase due to innovation. So why are recessions part of that process to higher productivity?

  • On the supply side… Some firms continue with lower productivity processes. They have contracts. They have market presence. They do not replace equipment that is less productive. So there is a force to push these firms to either increase productivity or get out of the way.
  • On the demand side… Effective demand constrains productivity. In the process of a business cycle, productivity gets limited by demand. In the sense that demand wears thin for increased production. Before many recessions, effective demand will expand allowing productivity to increase.

Recessions are a normal part of the cyclical growth process to push through the demand and supply constraints upon productivity. In the graph above, you will see productivity growth spurts after the recessions. Those are times when more productive firms can establish themselves more securely in the economy.

In China… Productivity has increased greatly there, right? Well, maybe… Productivity has slowed down greatly in China, and one could make a case that productivity is the most important problem in China. (link to WSJ article)

Eventually the less productive firms feel the increasing pressure from more productive firms.  There is a battle for market share and profits. Labor share normally rises, Inflation will rise. The economy will overheat in this battle for productivity. Nominal interest rates may rise to try to cool it down, but eventually the more productive firms gain advantage through the reshuffling process in a recession as profit rates become too vulnerable for the less productive firms.

Some recessions are better at supporting the advance of more productive firms. After the crisis, productivity had a nice quick growth spurt but then fell flat as less productive firms were protected within accommodative policies, most specifically monetary… and the stagnation of real wages.