The economy is standing on the precipice of entering into a recession. Leading indicators, economic indicators that precede the overall economy, are forecasting a 60.1% probability that we are already in a recession and a 98.4% probability that a recession will occur within 3-4 months. Nice.
Recessions are destructive by nature and cause significant harm. People lose their jobs. Companies go bankrupt. Asset values decline. Government revenue declines, impacting social programs. Mental health suffers. In summary, recessions cause widespread hardship and anguish.
Economic Darwinism – The Cleansing Effect of Recessions
Recessions are not necessarily bad, just painful. In fact, I would argue that they are indispensable and crucial for any society. Recessions are vital for any population to function normally. They force out excessive and poorly run aspects of the economy.
Think of recessions as the natural selection process of an economy. Just as natural selection favors traits and attributes within all populations of organisms, recessions favor companies and individuals that do the same while forcing out those that perform poorly.
Natural selection favored giraffes to feed on leaves others couldn’t reach, giving them a competitive advantage. Thanks to a better food source, those with longer necks could survive to reproduce and so pass along the same characteristics to the next generation. The same concept can be said about businesses.
Economic Darwinism leads to an efficient resource allocation because those firms with low profits are forced to quit while productive ones survive. Those surviving businesses offer higher value to consumers through higher quality and/or lower cost.
How Recessions Improve an Economy
During times of economic expansion, businesses typically expand rapidly, taking on too much debt and hiring more workers than they need. These businesses are forced to lay off workers and scale back their operations in a recession. This leads to a more efficient allocation of resources.
Efficient and well-managed businesses are not likely to go bankrupt during a recession. Instead, they will take more market share, providing consumers with better value (higher quality or lower prices). This leads to an increase in productivity and overall economic growth in the long run.
Innovation is encouraged during recessions as businesses are forced to find new ways to cut costs and stay competitive.
Recessions can also lead to improvements in labor market conditions. Of course, unemployment rises during recessions as businesses lay off workers. However, this can lead to a more efficient labor market over time, as workers are matched with the jobs that best suit their skills, and employers can fill open positions with the most qualified candidates.
Necessary and Normal
It is important to remember that recessions are normal and necessary. They are part of the business cycle that flushes out the excesses of our economy. They curb inflation, improve labor market conditions, and have long-lasting positive effects. It just sucks in the moment.