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Three Headwinds on the Current Recovery

As many commentators have noted, the recession of 2007–2009 has been one of the most severe since the Great Depression. Among all postwar recessions, it has been the longest, lasting from December 2007 to mid-2009, and it has suffered the largest increase in the unemployment rate, which went from 4.8 in February 2008 to 10.1 in October 2009.

Whereas recoveries after severe recessions have been generally V-shaped, that is, very rapid, the current recovery has been remarkably sluggish. It has been two and a half years since the beginning of the recession, and real GDP is still about 1 percent below the peak it last reached in the fourth quarter of 2007.

Real GDP

Why has the current recovery been so slow? Moreover, the forecast for the growth rate of GDP is quite low as well. Two headwinds on the current recovery were identified by the president of the Cleveland Fed, Sandra Pianalto, in a recent speech. The first is damage done to the labor market by prolonged and widespread unemployment. The percentage of workers unemployed long-term recently reached a historically high level. When workers remain unemployed for a long period, they are likely to become less productive in subsequent jobs. The large number of long-term unemployed workers is then a factor that may reduce aggregate productivity and may constrain economic growth going forward.

Unemployment Duration

The second headwind is the heightened sense of caution on the part of consumers and businesses due to deep economic uncertainty. In a more uncertain environment, consumers and businesses tend to be more cautious and delay spending and investment. One indicator of economic uncertainty is the volatility of the GDP growth rate. It measures the amplitude of fluctuations of the growth rate around its mean. After averaging 4.75 percent from 1950 to 1984, volatility fell to an average of 2.5 percent during the so-called Great Moderation. Recently, however, GDP volatility has spiked back to levels above 4 percent, pointing to an increase in uncertainty about future GDP growth.

Real GDP

Besides these two headwinds, an additional factor that may constrain the current recovery is ongoing financial imbalances. The household sector and the business sector owe too much debt relative to the value of their assets. During the economic expansion that preceded the recent financial crisis, both sectors became more indebted. The sudden fall of asset prices that occurred during the crisis caused a rapid deterioration of leverage ratios (ratios of liability to asset values). As a result, the balance sheets of businesses and households are currently very weak, with both high levels of debt and low asset values contributing to the weakness. The ratio of credit market debt to net worth is very high, by historical standards, for several sectors of the economy.

Debt as a Percentage of Net Worth

Weak balance sheets are known to depress spending and investment through several channels. For one thing, they reduce the availability and increase the cost of external funds, which businesses need to finance new investment projects. Also, when debt is large, interest payments are likewise large, and this burden directly reduces the internal funds available for spending. Furthermore, the desire by businesses and households to repair their balance sheets encourages saving and discourages spending. Finally, the overhang of existing debt distorts firms’ incentives to invest, leading them to invest less than would be optimal if they had fewer liabilities. Through all these channels, the weak balance sheets of the household and business sectors are likely to be a drag on consumption and investment for a while, making them another headwind on growth.

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