August 27, 2007 8:08

Is the American economy in need of a good cold shower?

In one of the most entertaining of the many entertaining passages in Robert Heilbronner's The Worldly Philosophers, Austrian-born economist Joseph Schumpeter regales his Harvard students in the mid-1930s with these encouraging words:

Chentleman, you are vorried about the depression. You should not be. For capitalism, a depression is a good cold douche. [By which he meant shower.]

I'm certainly not going to argue that the U.S. economy needs a 1930s-style depression. But I've been wondering for a few days now whether a standard-issue recession would really be such a terrible thing. Belts would be tightened. The thrifty and responsible would gain at the expense of the profligate and reckless. The trade deficit that preoccupies so many politicians these days would quickly shrink. The groundwork would be laid for a lasting expansion.

Of course, lots of perfectly decent, hardworking people would lose their jobs. Heck, I might lose my job, too. Still, we haven't had a full-fledged recession since 1991--the 2001 version was a sharp corporate downturn that, largely because of the Fed's super-loose monetary policy, never really hit consumers. Aren't we due?

It turns out the people at the Economist have been thinking similar thoughts. "Does America need a recession?" asks the Economics Focus columnist:

The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

The Economist concludes that it would be "political suicide" for Fed Chairman Ben Bernanke to follow such a course, but I'm not so sure. Openly advocating a downturn and praising the virtues of an economic cold shower would be problematic. But moving slowly enough that the housing correction is allowed to take its natural course and possibly steer the economy into recession might prolong Bernanke's career rather than end it. That's if you assume that a Democrat is likely to win the 2008 election. A recession late this year and/or early next would make such a victory even more likely, and give the winner even more leeway to push whatever economic policies he or she might prefer. Which might in turn endear him or her to the idea of reappointing Republican Bernanke when his term as chairman runs out in January 2010.

Hey, it worked for Alan Greenspan, didn't it?

Update: Economist Mark Thoma does not buy the recessions-are-good argument at all. And neither does Paul Krugman.