Are Recessions Necessary, and Even Good?

Laurence Hunt recently posted a question in a blog comment:

Bill, Do you believe the business cycle is intact, with the implication that recessions are healthy (creative destruction) and inevitable? If so, how meaningful would a shallow recession be in 2008. In other words, would a deeper recession be better (it’s been a long time)?

It’s a good question and merits an answer in the full blog.  There is a school of thought that says recessions are necessary corrections to fix past excesses.  Kind of like human suffering is the price we pay for Adam’s sin in the Garden of Eden.  I don’t buy it—I mean, the recession stuff.

The line of reasoning goes like this:  bad investments were being made.  Maybe it was tech back in the late 90s, or housing in recent years.  We needed to stop putting so much of our resources into these overbought sectors.  (This sounds like the Austrian malinvestment theory, of course.)

An alternative version of the hypothesis says we consumers have been spending too much.  We need to live within our means.

A recession stops bad investments and bad consumer spending.

My problem with this theory is two-fold.  Actually three, but I’ll ignore my third problem by just accepting that the premise is correct: that bad investment or spending decisions have been made recently.

Problem number one with the recession as cleansing solution is that you can get to the same result without a recession.  We do, sometimes, have soft landings after overexuberance.  Sometimes investors or spenders just dial back, without having been slapped in the face by recession.

My second problem is that the recession causes not only the stupid investment and spending to stop, but also a lot of good spending.  Plenty of projects that would really increase productivity are canceled due to weak cash flow.  Some consumers who had not been going overboard lose their jobs in the recession, forcing them to cut back even more.  These adjustments are all dead-weight losses to the welfare of the people of the country.

Recessions are like car accidents.  If you study a recession in detail, you see errors.  Somebody, or many somebodies, made a mistake.  Without that mistake, the recession would not have happened.  However, I won’t go so far as to say that the business cycle can be completely tamed.  Mistake are going to be made, accidents are going to happen.  The best we can hope for is a continuation of this Great Moderation, in which recessions are less frequent, and less severe when they occur.