How Recessions End

Recessions eventually end without government intervention, but it is likely to take a lot longer to happen.  Before Keynes, most classical economists thought that recessions were natural, inevitable, and even a good thing.  After a decade of the Great Depression in his cushy Harvard job, Austrian-educated economist Joseph Schumpeter said in 1939:

Commonly, prosperity is associated with social well-being, and recession with a falling standard of life. In our picture they are not, and there is even an implication to the contrary.  

In other words, Schumpeter thought that recessions may be associated with social well-being and economic expansions with a falling standard of living!  He explained that this is because:

…Times of innovation…are times of effort and sacrifice, of work for the future, while the harvest comes after.…The harvest is gathered under recessive symptoms and with more anxiety than rejoicing.…[During] recession…much dead wood disappears.  BC, 142-143.

So recessions are good because they are like a harvest festival when productive people can enjoy thanksgiving for their leisure as they enjoy their past “effort and sacrifice” and unproductive (people? capital? businesses?) are “dead wood” that must be pruned at during recession!  That is a really bad metaphor.  Similarly, Hayek thought that a fiscal or monetary stimulus could only make a recession worse and that they must end of their own accord without any effort to ameliorate them.   

How Recessions End:

1. Government monetary or fiscal stimulus makes markets clear.
2. Increase in ROI of new capital increases investment. 
1. Depreciation of old capital stock increases ROI of new capital:
• Keynes explained that capital decays and becomes obsolete over time until it becomes scarce enough to make replacement highly profitable. 
• Consumer durables also depreciate.  The US automobile fleet is older than ever and the number of housing units per capita has not been this low in many years. 
2. Technological advances increase ROI of new capital.  
3. Bankruptcy, savings, and refinancing repair balance sheets.  Liquidity constrained consumers and businesses feel free to borrow and spend again. 
4. Prices eventually get flexible in the long run and markets clear.  E.g.: real wages and housing prices drop reducing unemployment and increasing housing sales.  Nominal housing prices rise again and construction begins. 

As Krugman says, without positive government monetary or fiscal stimulus (#1 above), the adjustment, can go on for a long, long, long, long time.  

So let’s look at the NBER business cycle data. What we see is that some of those prewar slumps were really, really long: the Panic of 1873 was followed by a recession that lasted 5 1/2 years.

The NBER data shows that recessions have been getting shorter and less frequent, so something has been helping and better monetary policy (and automatic fiscal stabilizers) are probably part of the reason. 

BUSINESS CYCLE DATES		DURATION IN MONTHS
		Contraction	Expansion
		Peak to Trough	Previous trough to this peak
1854-1919 (16 cycles ‘Free’ Market) 1919-1945 (6 cycles Fed Era) 1945-2009 (11 cycles Keynesian Era)		22 18 11	27 35 59