Which production factor gets destroyed in major recessions, part II?

In a post a few weeks back, I raised the question of what additional production factor one would have to include into the current production function framework in order to have a plausible story about the recent crisis.

That post included a set of conditions any candidate would have to pass in order to fit the current crisis and be interpretable as a true factor of production. From the ensuing reactions, two main candidates emerged: a mystery factor that gives a role to lines of credit (suggested by James A); and input and output linkages (suggested by doctorpat, Ian King, and, implicitly, _Tel).
Let us now add more information to this question and see whether the proposed production factors have something to say about other major economic crises that we have known in relatively recent economic history.

The hope is that we need only one factor to generate a reasonable story for several major downturns. If  we’d need a very different new factor to explain each different major economic downturn, then the exercise of looking for new production factors becomes more futile because there is then less hope that having a good  explanation for each of the previous downturns will say anything of much use to inform us about what to do to prevent or cope with the next one.

Below is a graph that summarises the GDP movement of three other major economic downturns.

GDP movement during major recessions in the US, Russia and Indonesia
GDP movement during major recessions in the US, Russia and Indonesia

The blue line shows the Great Depression, in which case the 0 point on the X-axis denotes 1929; the red line shows the collapse of the Russian economy after the changes in 1990; and the green line shows the Indonesian collapse after the Asian Financial Crisis of 1997. In each case, GDP is normalised to be 100 at the start of the crisis and time is re-set to 0 at the start.
The first striking observation is that these three crises are far bigger in magnitude than the current crisis. Indeed, the Russian collapse was so spectacular that I have long wondered how it is possible that our macro-textbooks are not full of insights gained during such a spectacular macro-event. Stiglitz already noted in the 90s that the Russian collapse shouldn’t have occurred under the conditions we still teach as good descriptions of the aggregate economy, but it clearly hasn’t mattered for Western textbooks that a large economy on the periphery did something interesting.
The main question to briefly consider though, is whether the two candidate factors X are known to have been involved in these downturns too? Lines of credit were certainly important in the Russian case (as in the whole of the former USSR), where firms had large amounts of outstanding debt with other firms and the unwinding was a tricky business.

Lines of credit were also important in Indonesia and the Great Depression. Hence credit lines can at least potentially ‘fit’, though it should still be worked out via which actual production factor they affect sold production.

Linkages are clearly of relevance in the Russian case where the whole central coordination mechanism fell away and the ensuing ‘disorganisation’ (A phrase used by Blanchard and Kremer 1997) created many firms who had no suppliers and no clients. Campos and Coricelli in their 2002 Journal of Economic Literature article also point to within-sector reorganisation of links as a probable factor in the collapse.

Whilst linkages are probably relevant in the Asian Financial crisis, it is not well-documented how they might have played a role. We know many city labourers went back to the countryside, however exact numbers are unknown because most people who originally came from the country to find urban employment are unregistered and therefore not included in unemployment and migration data etc (explanation paraphrased from a paper by Tran Tho Dat).
We also know that the capital embedded in collapsing firms was not quickly re-used by others, but there’s no specific account I know of that  discusses the collapse in terms of broken linkages.

For the Great Depression, on which acres have been written, I also do not know of anyone looking at it through the lens of links. One might say it is implicitly there when people talk about the issue of bankruptcy, as bankruptcy to a perfect market economist merely means the freeing up of previously inefficiently used production factors. From a link point of view, the importance of bankrupcy is that people and capital are idle for quite a while before they are ‘re-linked’.

Any ideas on how we should think of disruptions in lines of credit and its impact on the real economy via a production factor in these three crises or the current one? Any anecdotes on links?

Author: paulfrijters

Professor of Wellbeing and Economics at the London School of Economics, Centre for Economic Performance

6 thoughts on “Which production factor gets destroyed in major recessions, part II?”

  1. I think that size of the Russian collapse isn’t surprising. They were in an autarkic economy, and what they found when they opened up was that all of their capital had depreciated to zero – when they had to compete with Caterpillar to make tractors eg they found out that their capital was worthless, even in heavy industry where the communist bloc focussed their efforts. Not only that but human capital was not trained sufficiently in areas that are relevant to a modern economy.  Once they opened up and GDP was measured according to proper prices, GDP fell back to reflect these issues.
    As for credit and growth, Aghion and Howitt have some models in Chapter 6 of their book which incorporate credit growth into various models.

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  2. Hi Mark,

    I beg to differ. Its not just official GDP that halved. Electricity usage witnessed a similar decline; levels of absolute and experienced poverty went through the roof; suicide rates and substance abuse sky-rocketed, leading Michael Ellman (I would say one of the major Western economic observers of trends in Russia) to call the transition a ‘Katastroika’. By any reasonable indicator, the collapse of the economies of the former USSR really did happen, which you cant just ‘explain away’ by assuming instantaneous full depreciation of physical and human capital.

    The answer you give – they were already poor and the initially higher GDP was all mismeasurement – is typical of the attitude of many Western macro-economists to the 1990s transition in Eastern Europe. They are so desparate not to have to explain the halving of a dozen major economies, they are prepared to pretend it didn’t really happen.

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  3. I’m not saying it didn’t happen. It did happen. But all of those firms in Russia that had to compete simply weren’t able to do so. One of the reasons that Thatcher was so influential with Gorbachev is that Gordievsky defected from Russia with data that suggested that the USSR was spending 1/3 to 1/2 of their GDP on the military. GDP was much weaker than the west had thought until that time. At that time a flight from Vladivostok to Moscow cost $7. That is not an economy with an efficient allocation of resources or the right price signals. It is not surprising when that system fell apart that the economy fell into chaos. And my view is that the gradualism of China is far less risky than the Russian approach to reform. As for electricity demand halving, surely prices are important. Our former colleague Katya used to keep her windows open in Siberia in winter to “let in fresh air”. The price of electricity was close to zero until the reforms.
    I’m not sure why you give the political interpretation to my statement. On the contrary, I do think that Russia was devastated by communism, and the restructuring was incredibly painful. The problem now is that they are reverting again to communism under Putin.
    For more on Gordievsky’s defection see “The Battle for Norilsk”, which is available online on PBS.

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  4. Hi Mark,

    I guess we’d want to translate your notion of competitiveness into production function language before we can be sure what we are arguing about. You say ‘But all of those firms in Russia that had to compete simply weren’t able to do so.’ Within the usual production function set-up there is no such thing as ‘having to compete with international competitors’: prices adjust instantaneously so that local producers obtain the value of the goods they produce, nothing more and nothing less. I guess one could say that within that world, internal relative prices had to adjust as the control system on prices was lifted. Then the question emerges via which missing production factor the adjustment in relative prices caused real economic decline.
    I suppose you could argue that the collapse of the control system caused a massive shift in preferences away from locally produced goods to foreign produced goods, but then the same quesiton emerges as to why there should be such a large decline in the adjustment to producing the new goods valued.

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  5. I guess my point would be that we usually start using growth models under assumptions of efficient allocations as well as CRS etc. In Russia the planners didn’t use things like the NCG models, they used input-output analysis which at least makes more sense in a world where allocations aren’t efficient.  So I wouldn’t be sure you could translate it into production function language.  Isn’t your last point assuming putty-putty capital? I guess I’m just not that convinced that the capital in Russia circa 1990 is that useful in producing those new goods? Aside from the fact that areas like the services sector are neglected under capitalism and it takes a while to develop expertise to supply that.

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