The scarring effect of recessions

Abstract

This paper explores the role that recessions play in resource allocation. The conventional cleansing view, advanced by Schumpeter in 1934, argues that recessions promote more efficient resource allocation by driving out less productive units and freeing up resources for better uses. However, empirical evidence is at odds with this view: average labor productivity is procyclical, and jobs created during recessions tend to be short-lived. This paper posits an additional "scarring" effect: recessions "scar" the economy by killing off "potentially good firms". By adding learning to a vintage model, I show that as a recession arrives and persists, the reduced profitability limits the scope of learning, makes labor less concentrated on good firms, and thus pulls down average productivity. Calibrating my model using data on job flows from the U.S. manufacturing sector, I find that the scarring effect is likely to dominate the conventional cleansing effect, and can account for the observed pro-cyclical average labor productivity.

Shaking Up the Firm Survival: Evidence from Yogyakarta (Indonesia)

“…In contrast, Barlevy (2002) Therefore, the overall impact of economic shocks like recessions on the allocation of resources depends on the relative magnitude of cleansing and scarring effects (Ouyang 2009). …”

“…This is known as the 'scarring effect of shocks' (Ouyang 2009). Therefore, the overall impact of exogenous shocks on the allocation of resources depends on the relative magnitude of cleansing and scarring effects.…”

How does monetary policy affect labor demand and labor productivity?

“…Cleansing effects support productivity whereas scarring effects weaken it. In one model, both cleansing and scarring effects exist and shape productivity growth via resource reallocation effects, including through business entry and exit [12]. The cleansing effect results from low productivity companies exiting during a recession.…”

Shaking up the Firm Survival: Evidence from Yogyakarta (Indonesia)

“…However, the shocks may also force out young firms that have the potential to be highly productive in the future, which will lower the average productivity of industry. This is known as the 'scarring effect of shocks' (Ouyang 2009). Therefore, the overall impact of exogenous shocks on the allocation of resources depends on the relative magnitude of cleansing and scarring effects.…”