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Do Recessions Clear the Way for More Productive Firms?

Conventional economic theory holds that recessions, while painful, have a beneficial effect on economic productivity because they eliminate inefficient firms and clear the way for more productive ones. Unless the market demand for a company’s offering is iron clad, a recession will make it very hard for them to operate, and so poorly performing firms will fail in large numbers.

Now a group of economists at the University of Virginia revisited this question, to understand if the experience of the Great Recession and the presence of certain modern financial phenomena like credit frictions have changed this equation. (Credit frictions are a disfunction in credit markets that distorted the cost of trading, and made the effects of the Great Recession much more prolonged than they would have been otherwise.)

Osotimehin and Papadà confirm that recessions do, in fact, have a cleansing effect.

They conclude that, while some high performing firms will die in a recession together with the masses of inefficient ones, they do so much less frequently than inefficient firms. Overall productivity in the economy increases after a recession, because the proportion of productive firms grows – even in today’s financial environment.

To find out more, please read the original article called Credit Frictions and The Cleansing Effect of Recessions, or Papadà’s summary in the LSE Business review here.

Contributed by Lili Torok.

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