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THE ‘CLEANSING EFFECT’ OF RECESSIONS: Average firm productivity is boosted but by less when financial conditions are tight

  • Published Date: June 2017

When an economic downturn is driven by tightening financial conditions, the typical boost to overall productivity that comes from weaker firms closing down is reduced. Nevertheless, there is a still a ‘cleansing effect’ as any recession raises the exit rate of low productivity firms more than that of high productivity firms.

These are the central findings of research by Sophie Osotimehin and Francesco Pappadà, published in the June 2017 issue of the Economic Journal. Their results have significant implications for the analysis of the costs of recessions. The authors comment:

‘Not all distressed firms are unproductive. An accurate assessment of the nature of the shock – as well as the productivity of distressed firms – appears to be key to evaluate fully the costs of recessions.’

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During the Great Recession, the annual exit rate of US establishments increased from 11.8% to 13.5%. The conventional view is that the increase in the exit rate during the recession improves the allocation of resources. But does this ‘cleansing effect’ of recessions hold when firms face financial constraints?

The new study finds that a recession leads to an increase in average firm-level productivity even in the presence of credit frictions. But the intensity of the cleansing effect is lower in the aftermath of a financial shock.

This result suggests that the nature of the recession is relevant for the cleansing effect: the exit of firms is less productivity-enhancing when the recession is characterised by a tightening of financial conditions.

The cleansing effect of recessions has been motivated by the view that during recessions, low productivity firms are forced to shut down as they become no longer profitable; this would then allow resources to be reallocated towards more productive firms.

The idea goes back to Joseph Schumpeter who saw recessions ‘not simply as evils, which we might attempt to suppress, but – perhaps undesirable – forms of something which has to be done, namely, adjustment to previous economic change.’

The implicit assumption that markets select the most productive firms has been challenged by several empirical studies showing that firms’ probability of exit depends not only on their productivity but also on their access to credit. In the presence of credit frictions, firms that exit are not necessarily the least productive firms. Does the presence of credit frictions wipe away the potential benefits of recessions?

This study builds a model of firm dynamics with endogenous exit and credit frictions to investigate this question. Calibrated to match the observed exit rate, the productivity distribution and the level of credit frictions in the US economy, the model indicates that credit frictions do modify the selection of exiting firms. In particular, high productivity firms may exit if they are under financial duress.

But despite their effects on the selection of exiting and entering firms, credit frictions do not reverse the cleansing effect. Average productivity increases following an adverse aggregate shock even when firms face credit frictions, as the shock predominantly raises the exit rate of low productivity firms.

The researchers also explore how the nature of the recession shapes the cleansing effect. When the economic downturn is driven by a tightening of financial conditions, the intensity of the cleansing effect is lower. A larger fraction of high productivity firms exit in response to a financial shock, thus reducing the productivity-enhancing effect of recessions.

These results suggest that an accurate assessment of the nature of the shock, as well as the productivity of distressed firms appears to be key to evaluate fully the costs of recession.

ENDS


Notes for editors: ‘Credit Frictions and the Cleansing Effect of Recessions’ by Sophie Osotimehin and Francesco Pappadà is published in the June 2017 issue of the Economic Journal.

Sophie Osotimehin is at the University of Virginia. Francesco Pappadà is at the Banque de France.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or Sophie Osotimehin via email: sophie.osotimehin@virginia.edu