The Economics of Recession: A Survey
Part 9/10, November 2022 [1]
Arturo Estrella

9. Managing the individual risks of recession

          Several earlier references attribute to central banks the power to create recessions, and they further claim that central banks have deliberately created recessions in order to keep inflation under control. If that view is correct, recessions are most likely an inescapable recurring feature of modern economic life. Confronted with that reality, rational households and businesses would be expected to take precautions in anticipation of possible recessions and to have in store optimal plans of action to be executed once a recession is underway. The articles in this section examine the optimizing behavior of firms before and during recessions.

          In the model of Ang and Smedema [R59], firms have an optimal time-varying amount of desired financial flexibility, which fluctuates cyclically as a function of the probability of a recession 12 months ahead, among other factors. A higher probability of recession increases the desire of the firm to hold cash or other liquid assets in anticipation of losses in case of recession. If changes in financial flexibility are costly, the firm makes a partial adjustment each period to the desired level of financial flexibility. Using U.S. data from 1980 to 2008, the authors obtain econometric estimates of various alternative specifications of the model, which they use to inquire whether U.S. firms act optimally as in the model. Aggregate results suggest that firm behavior is suboptimal in that they tend to ignore forecasts of upcoming recessions. However, when the sample is disaggregated into cash-constrained and unconstrained firms, results for the latter are consistent with optimization, while cash-constrained firms are unable to optimize, which clouds the aggregate results.

          Caballero and Hammour [R60] model the response of firms once a recession is underway and its consequences for an industry in the aggregate. The model incorporates the Schumpeterian view of creative destruction, but here there is also a response along another margin with different implications. Units that are technologically outdated are scrapped, as in Schumpeter’s approach, producing what the authors term the “cleansing effect” of recessions. However, there is also a “creation margin” in which firms respond to a reduction in demand by cutting back on the creation of new units endowed with up-to-date technology if the process of creation is costly. This second effect may insulate some of the outdated units that would otherwise be eliminated, since firms may be unable to replace them on a cost-effective basis.

          Using a calibrated version of the model, the article explores implications for job creation and job destruction and compares the quantitative results with actual U.S. data from 1972 to 1983. The model matches job destruction more closely than job creation, but the relative smoothness of job creation over the business cycle matches a stylized fact about the data. Variation along the creation margin is attenuated by costs, as in the theoretical model, partly insulating the outdated units and reducing the cleansing effect of recessions.

Readings referenced from book The Economics of Recession

R59    James Ang and Adam Smedema (2011), ‘Financial Flexibility: Do Firms Prepare for Recession?’, Journal of Corporate Finance, 17 (3), June, 774–87

R60    Ricardo J. Caballero and Mohamad L. Hammour (1994), ‘The Cleansing Effect of Recessions’, American Economic Review, 84 (5), December, 1350–68

[1] The original version of the survey was published in The Economics of Recession, Edward Elgar Publishing, 2017.