In the aftermath of the recent global financial crisis, economists have been once again forced to think about the long run consequences of short run fluctuations. The conventional wisdom holds that in many developed countries economic activity will remain depressed and unemployment will remain high for several years to come. Such projections have, once again, bolstered the interest of economists in studying the long run consequences of recessions.
Two separate strands of the literature have dealt with this topic both from an aggregate and a micro perspective. The former has analyzed the behavior of unemployment, employment and economic activity and has found that crises, or recessions more generally, leave permanent or long lived scars on economic activity and employment. The latter has focused on how short run fluctuations affect firm dynamics. Our paper is more closely related to the second approach.
To our knowledge, most of this literature had analyzed the cleansing and scarring effects of recessions. The notion that recession may have “cleansing” effects can be tracked down to the Schumpeterian idea stressing the benefits of creative destruction. For instance, Caballero and Hammour (1994) stress how recessions could be a time of cleansing, that is, a time when firms with outdated techniques are pushed out of the market.
As opposed to the aggregated view that stresses that recessions can have long lasting negative effects, this literature suggests that through the exit of low productivity firms in recessions, aggregate productivity may increase, and in a way a current recession may lead to a positive long term outcome, or at least one in which no permanent scar is left. A way to reconcile the aggregate findings with the micro principles is by exploring the role played by credit constraints in explaining firm dynamics during recessions.
Most of the literature that suggests that crises have “cleansing” effects, assumes perfect financial markets. This is not robust to the presence of credit frictions, especially when efficient production arrangements are vulnerable to credit constraints. For instance, Barlevy (2003) argues that credit constraints might lead to an inefficient allocation of resources, particularly in bad times. If efficient firms rely more on credit, a tightening of credit conditions will have a disproportionate adverse effect on efficient firms relative to less efficient ones. From an empirical standpoint, this means that firms with relatively high productivity, but which are credit constrained and therefore cannot face recessions successfully, may be forced to exit the market when faced by an aggregate shock. The shedding of high productivity firms could be productivity-decreasing at the aggregate level and would be consistent with a long run reduction of aggregate TFP.
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Credit Constraints, the Business Cycle and Firm Dynamics in Colombia
