The Scarring E¤ect of Recessions

According to the conventional Schumpeterian view, recessions improve resource allocation by driving out less productive producers. We posit that recessions bring an additional scarring e¤ect by impeding the developments of potentially superior producers, which can be destroyed during their infancy and never realize their potential. A model combining creative destruction with learning is developed to capture both the cleansing and scarring e¤ects. A key ingredient of our model is that idiosyncratic productivity is not directly observable, but can be learned over time. When calibrated with statistics on productivity and on cyclical entry and exit, the model suggests that the scarring e¤ect can dominate the cleansing e¤ect, and can give rise to lower average productivity during recessions.