A Forest Fire Theory of Recessions and Unemployment

We develop a model of matching from firms' perspectives and draw resulting conclusions for the macro-dynamics of an economy. The key insight is that firms may wish to hire workers that are bad matches (having low productivity) in high-demand states, even if the worker must be hired to a long-run contract. This results an increasing fraction of bad worker-firm matches as an economy booms, making it increasingly likely that a recession will occur the longer it has been since the last recession, and increasing the depth of the recession when it occurs. While employment is lowest immediately following a recession, an economy has its highest fraction of good to bad matches as it emerges from a recession. These dynamics result in fully-rational, endogenous business cycles featuring non-stationary distributions of unemployment for a given stationary exogenous shock: in particular, the longer it has been since the last recession the more fragile the economy becomes and the more dramatic its response to exogenous shocks. Examining US economic areas data from 1969-2011, we find that the longer the time elapsed since the last recession, the larger the drop in employment during the recession.