The Cleansing Effect of Recessions By RICARDO J. CABALLERO AND MOHAMAD L. HAMMOUR* We investigate industry response to cyclical variations in demand. Production units that embody the newest process and product innovations are continuously being created, and outdated units are being destroyed. Although outdated units are the most likely to turn unprofitable and be scrapped in a recession, they can be "insulated" from the fall in demand by a reduction in creation. The structure of adjustment costs plays a determinant role in the responsiveness of those two margins. The calibrated model matches the relative volatilities of the observed manufacturing job creation and destruction series, and their asymmetries over the cycle. (JEL EOO, LOO, JOO) This paper investigates the response of back at least to Joseph A. Schumpeter (1939, industries to cyclical variations in demand 1942), although we do not go so far as to in the framework of a vintage model of adopt his view that the process of creative "creative destruction."' Our premise is destructionthat is itself a major source of eco- the continuous process of creation and de- nomic fluctuations (as in Andrei Shleifer struction of production units that results [1986]). Our emphasis here is on variations from product and process innovation is es- in demand as a source of economic fluctua- sential for understanding not only growth, tions, and on the way a continuously reno- but also business cycles.2 This idea goes vating productive structure responds to them. A stark example of this effect of demand on industry structure has been recently doc- *Caballero: Department of Economics, Mas- umented by Timothy F. Bresnahan and sachusetts Institute of Technology, Cambridge, MA 02139; Hammour: Department of Economics, Columbia Daniel M. G. Raff (1991, 1992) in their University, School of International Affairs, New York, study of the effect of the Great Depression NY 10042. We thank John Haltiwanger for helpful comments and for providing us with job-flow data. We also thank Olivier Blanchard, Peter Diamond, Julio Rotemberg, three anonymous referees, and workshop participants at Boston College, Boston University, the University of Chicago, Columbia University, the Uni- versity of Maryland, UQUAM, the NBER Summer Institute 1991 and the NBER EFRR 1992 meeting in Palo Alto for useful comments. Caballero thanks the National Science Foundation and the Alfred P. Sloan estimates of embodied technical change, Hulten (1992) Foundation for financial support. argues that as much as 20 percent of the change in IIn independent work, Dale Mortensen and total factor productivity can be directly associated with Christopher Pissarides (1991, 1992) study issues similar capital embodiment. Bartelsman and Dhrymes (1991) to the ones considered in this paper in the context of a and Baily et al. (1992) use plant-level data to decom- search model of unemployment. pose improvements in aggregate productivity into a 2For an analysis of creative destruction in Leif component due to resource allocation from relatively Johansen's (1959) vintage model of embodied tech- inefficient to relatively efficient plants, and another due nical progress, see Robert M. Solow (1960), Edmund S. to improvements in technology purely at the plant Phelps (1963), Eytan Sheshinski (1967), and references level. Both studies find that a major part of technical therein. For two recent models of growth through progress arises from factor reallocation, a fact consis- creative destruction, see Gene R. Grossman and El- tent with the view of an economy subject to ongoing hanan Helpman (1991) and Philippe Aghion and Peter creative destruction. Compounded over the period Howitt (1992). 1972-1987 for a sample of 22 industries, the results in For recent analyses of the empirical significance of Baily et al. (1992) indicate that aggregate growth is creative destruction for growth, see Eric J. Bartelsman made up of 6.7 percent due to reallocation and 3.5 and Phoebus J. Dhrymes (1991), Martin N. Baily et al. percent due to plant-level technical progress (results (1992), and Charles R. Hulten (1992). Using price-based for "all industries except 3573" in their table 1, p. 207). 1350 This content downloaded from 18.9.61.112 on Tue, 31 Jan 2017 19:53:21 UTC All use subject to http://about.jstor.org/terms VOL. 84 NO. 5 CABALLERO AND HAMMOUR: CLEANSING EFFECT OF RECESSIONS 1351 on the American motor vehicles industry. The interaction of two margins can chal- Using Census panel data, they find that the lenge one's intuition. We isolate two ef- large contraction in automotive production fects. Old production units, having an was the occasion for a permanent structural inferior technology, can more easily turn change in the industry. At the beginning unprofitable and be scrapped in a recession of the Depression, the diffusion of mass- than new ones. However, units in place may production techniques in manufacturing had not experience the full fall in demand if it is only been partial, and a substantial segment accommodated by a reduction in the cre- of the industry was still based on skilled ation rate. We investigate the extent to craftsmanship. Plant shutdown, which ac- which this "insulating" effect of creation counted for a third of the decline in indus- will operate and reduce the responsiveness try employment during the Depression, was of destruction to demand. The structure of concentrated in smaller, less productive adjustment costs turns out to play a deter- craft-production plants, while plants that minant role in the extent to which insula- had adopted the mass-production system tion will take place. When adjustment costs had a competitive advantage that made them are linear, we show that insulation is com- more likely to survive. The result was a true plete, and the industry responds exclusively shakeout or "cleansing" of the productive on its creation margin. As the motive for structure, as most plant shutdowns were smoothing the creation process over time permanent. Interestingly, creation was still becomes more important, insulation be- taking place alongside this massive destruc- comes more limited, and the destruction tion process, with a sizable number of new margin becomes more responsive. plants entering even in the depths of the What is the empirical evidence on the Depression.3 cyclical responsiveness of creation and de- In general, industries undergoing contin- struction? We next turn to the U.S. evi- uous creative destruction can accommodate dence on gross job creation and destruction variations in demand in two ways: they can collected by Olivier J. Blanchard and Peter vary either the rate at which production A. Diamond (1990) and Steven Davis and units that embody new techniques are cre- John Haltiwanger (1990, 1992). As empha- ated or the rate at which outdated units are sized by Blanchard and Diamond, the si- destroyed. The central question becomes: multaneous high observed rates of job cre- along which of these two margins will busi- ation and destruction in narrowly defined ness cycles be accommodated? sectors lend plausibility to the view of an Since a representative-firm economy is economy subject to ongoing creative de- unsuited to answer this question, we ad- struction. This view is further confirmed by dress it in the context of a simple theo- the strong persistence of job destruction at retical model of creative destruction with the plant level documented by Davis and heterogeneous technologies.4 Production Haltiwanger (1990). We analyze Davis and units embody the most advanced techniques Haltiwanger's (1990, 1992) data on manu- available at the time of their creation. Cre- facturing job flows in light of our model. ation costs slow down the process of tech- The evidence is that job destruction is much nology adoption and lead to the coexistence more cyclically responsive than job creation. of production units of different vintages. Thus, the insulating effect of creation seems This decouples the two margins and permits very imperfect. According to our model, this a meaningful analysis of the issue at hand. is due to the structure of creation costs that gives a motive for smoothing the creation process. Interestingly, the data exhibit fea- tures that provide a natural experiment to 3In the 1929-1931 period, industry 1408 saw 13 new test this explanation. Noting that business plant entries and 60 exits. During 1931-1933, those cycles are highly asymmetric, with reces- numbers were 9 and 45. sions shorter but much sharper than expan- 4A steady-state variant of this model has been used by Boyan Jovanovic and Saul Lach (1989) to study sions, our model would predict that those technology diffusion. asymmetries would be smoothed out in the This content downloaded from 18.9.61.112 on Tue, 31 Jan 2017 19:53:21 UTC All use subject to http://about.jstor.org/terms 1352 THE AMERICAN ECONOMIC REVIEW DECEMBER 1994 creation process. The evidence confirms this output throughout its lifetime. Technical prediction: creation is roughly symmetric progress makes the productivity A(t) of the around its mean, while destruction is highly leading technology at time t grow at an asymmetric. exogenous rate y > 0. The view that emerges from interpreting Although we interpret the creation pro- the greater cyclicality of job destruction cess as one of technology adoption, it could along creative-destruction lines is one of also be interpreted as one of product inno- recessions as times of "cleansing," when vation. In this case, there is a continuum of outdated or relatively unprofitable tech- perfectly substitutable products that yield niques and products are pruned out of the different utilities. A production unit created productive system-an idea that was popu- at to will be producing a unit flow of the lar among pre-Keynesian "liquidationist" most advanced product in existence at to, theorists like Hayek or Schumpeter (see J.