Less regulation means shorter recessions

In recent years, many economists on the left of the political spectrum, such as Joseph Stiglitz and Paul Krugman have argued that laissez-faire policies have made banking crises (like the Global Financial Crisis) more likely.

But, even if this were true is it a mark against them? It depends. As Scott Sumner points out not every banking crisis becomes a recession. Indeed, one study by Dwyer et al, found that one in four banking crises didn't lead to a fall in GDP per capita in the following two years. And countries that experience occasional financial crises typically grow a lot faster than countries with more stable financial conditions.

What matters then, is not the likelihood of a banking crisis, but whether an economy is more or less likely to make a quick recovery.

According to a working paper by Christian Bjørnskov, economies with greater levels of economic freedom (in particular greater levels of regulatory freedom), recover faster and more likely to stop an economic crises from becoming a recession. Looking at 212 crises across 175 different countries, he found that countries with high levels of regulatory efficiency (as measured by their score on The Heritage Foundation's Index of Economic Freedom) tended to have shallower and shorter recessions.

Why might this be? Bjørnskov gives a few possible reasons.

"As a crisis hits an economy, a substantial share of resources become unemployed, which creates profit opportunities for entrepreneurs to the extent that these resources become cheaper. Yet, whether or not this happens and at which speed existing firms and new entrants can reallocate resources depends on the regulatory framework.

Licensing requirements and similar business regulations constitute entry barriers that prevent entrepreneurs from seizing legal opportunities and thereby limiting the economic and social losses during crises. Unstable monetary policies and inflationary interventions prevent the formation of precise price expectations, thereby increasing uncertainty, which would also hold back new investments (Friedman, 1962).

Finally, labour market regulations can make it both more expensive and risky to hire new employees, providing a third channel through which deficient or inefficient regulations significantly increase the transaction costs of reallocation. Consistent with the evidence, this does not prevent a crisis from occurring, but limits its extent as more firms in a flexible economy can react faster and in a more economical way to the challenges and opportunities created by the crisis."

Recessions that forces business to cutback, lay off workers and even shut down may be painful, but they also allow for the creative destruction and dynamism that benefit us all. But it's only when regulatory barriers are low, inflation is predictable, and labour markets are flexible, that entrepreneurs can take advantage of those opportunities quickly enough to avoid a prolonged slump.