Quarter 4, 1998
by Scott Schuh and Robert Triest

Recessions, like death and taxes, cannot be avoided forever. But what will cause the next recession? More than fifty years after the Great Depression, what causes economic downturns is still a largely unsolved puzzle. The traditional explanation is that recessions are caused by events that have an economy-wide impact, such as an increase in interest rates or a decline in consumer confidence. Firms reduce output and lay off workers, which further decreases demand, and the economy slows even more.

But, some firms add staff during recessions, even as others are reducing their workforce. So some economists have suggested that recessions might be caused not by economy-wide changes, but by events that hurt particular firms or industries. They speculate, for example, that a major innovation or a change in the price of a key input can adversely affect some firms, causing them to reduce production and discharge workers, while other firms are helped and seek additional workers. Since it takes time for displaced workers to find jobs with new employers, a recession may occur during this period of "reallocation."

The recessions that followed the dramatic increases in the price of oil in 1973 and 1979 were due, at least in part, to such changes. Businesses for which demand was sensitive to energy prices, such as full-sized cars, suffered a sharp decrease in orders and were especially likely to contract. Those that required a lot of energy to run machinery faced higher-than-typical cost increases and were also more likely to reduce output and staff. It took time for displaced workers and other resources to be reemployed elsewhere. In the meantime, the economy experienced a recession.

Most recessions involve a tangle of forces. The 1970s' oil shocks also set off an economy-wide decline in demand as real income was reduced by the higher cost of oil imports and tighter monetary policy dampened the inflationary pressures which followed the price increases. These factors slowed overall demand, and so were also partly to blame for the subsequent recessions. And, such a drop in demand may cause further job destruction. Thus, aggregate forces can play an important — perhaps even a dominant — role in recessions, even if allocative forces provide the trigger.

Yet, paying attention to forces that can produce reallocation may help us spot the seeds of future slowdowns and bursts of growth. The Asian economic crisis is having a disproportionate impact on firms that export to Asia or compete with Asian imports and might trigger a reallocation away from these sectors. Looking ahead, the Y2K computer problem varies in its impact across firms and industries. On the positive side, progress in communications and information technology may be a source of favorable reallocation, with workers and entrepreneurs shifting to these sectors. The relative strength of such forces may determine the future course of the business cycle.

Scott Schuh and Robert Triest are Economists at the Boston Fed.