Self-correction means self-destruction for economies

Economic and financial crises induce permanent loss of output in the absence of monetary and fiscal intervention.

Self-correction does not merely wipe out insolvent firms. Solvent firms of good times become insolvent due to plunging revenues in recessions.

Fiscal and monetary expansion render firms solvent back by enhancing their revenues. Allowing for self-correction would lead to massive bankruptcies due to a depressed demand taking a longer time to revive.

Central banks' effort to boost expenditure may fall short when banks halt credits, anticipating a soaring delinquency rate.

Self-correction leads to self-destruction

Throughout the history, economists have discussed whether markets self-correct or not. In fact, this discussion should also include at what cost do markets self-correct even if they do. High burden is the underlying reason whey authorities all over the world do not allow markets to self-correct.

It is true that crises are a type of efficiency control over the economies. Inefficient firms cannot survive a recession when their abilities to access funds are limited. Nevertheless, self-correction does not merely clean out insolvent firms. Solvent firms of good times become insolvent due to plunging revenues in recessions. Fiscal and monetary expansion render firms solvent back by enhancing their revenues. Waiting for self-correction would lead to massive bankruptcies due to a depressed demand.

Authorities avoid destructive bankruptcies of financial and economic crises. Because bankrupt firms cannot find buyers in bad times, they are mostly liquidated. Mass-liquidations induce a permanent loss of production capacity and employment. Liquidated firms' production does not come back even after the recovery. Mass-defaults in economic and financial crises thereby prevent economies from returning to their long-term output trends. After the 2008 financial crisis, European Commission (2009) anticipated a permanent output loss in the absence of strong policy responses.

Financial and economic crises trigger each other

Policy makers step in the economic and financial crises since one can trigger the other one. The 2008 crisis was a financial one at origination. Output contracted when financial resources stopped flowing into the real economy. Likewise, a recession may result in a financial crisis. As economic entities lose income and revenues due to surging layoffs and shutdowns, they can not acceleratingly serve their debt. As a result, surging delinquencies jeopardize capitals of financial agencies. A well capitalized bank reserves a capital as much as 15% of its loans. Amid a protracted recession, a 15% loss from loans over a few years can lead a bank to the brink of collapse.

Response of financial agencies to the materialisation of credit risk exacerbates economic conditions. The financial system squeezes credits to insolvent borrowers to preserve equity from further losses. Nevertheless, the line between solvent and insolvent blurs in recessions. Insolvent borrowers of bad times are mostly the profiting ones of good times. A firm can easily lose its equity while its revenues slump amid an economic downturn. A credit rationing would remove the likelihood of survival for the firms in need of working capital. Massive shutdowns impair financial capitals by amplifying delinquencies through a higher unemployment.

Conclusion

Crises are solvency tests for economic entities. In the absence of policy intervention, over-leveraged and insolvent actors would be eliminated from the economy in economic downturns. Nevertheless, such a self-correction would likely not confine to zombie firms. Mass-defaults exacerbate economic and financial conditions for other firms as well. While revenues are plummeting in a recession, profitable firms can also incur destructive losses and lose their equities.

Response of both the real and financial sector to financial and economic shocks leads to a permanent output loss. To alleviate losses, firms lay off workers and financial agencies shrink credits. Those reactions further depress spending and suffocate revenues of businesses. As long as the real sector cannot raise revenues, the financial sector cannot be better off. Therefore, fiscal and monetary authorities promote spending in recessions.