The Scarring Effect of Recessions

This paper explores the role that recessions play in resource allocation. The conventional cleansing view, advanced by Schumpeter in 1934, argues that recessions promote more efficient resource allocation by driving out less productive units and freeing up resources for better uses. However, empirical evidence is at odds with this view: average labor productivity is procyclical, and jobs created during recessions tend to be short-lived. This paper posits an additional "scarring" effect: recessions "scar" the economy by killing off "potentially good firms". By adding learning to a vintage model, I show that as a recession arrives and persists, the reduced profitability limits the scope of learning, makes labor less concentrated on good firms, and thus pulls down average productivity. Calibrating my model using data on job flows from the U.S. manufacturing sector, I find that the scarring effect is likely to dominate the conventional cleansing effect, and can account for the observed pro-cyclical average labor productivity