Mighty Bad Recessions
No two recessions are exactly alike. They differ in terms of their depth and duration, their diffusion across various industries, and the economic shocks that set them off. Nevertheless, recessions often share basic characteristics that determine their severity and the pace of subsequent recoveries. Recently, the International Monetary Fund (IMF) has been studying two of these—association with a financial crisis and global reach—to see how they affect a recession’s contours. The implications for our current global economic malaise, which shares both of these characteristics, are sobering. They explain why the current global downturn is the worst since the Great Depression.
The IMF investigated business cycles which occurred between 1960 and 2007 in 21 advanced countries. Researchers wanted to know if recessions associated with financial shocks and recessions highly synchronized across countries were distinct in their depth and duration from recessions with different characteristics. The sample yielded 122 recessions, 15 of which were associated with financial crises, 37 of which were highly synchronized across the globe, and 6 of which got a double whammy.
Recessions associated with financial crises are deeper and longer lasting than recessions associated with other types of economic shocks. In addition, their recoveries are slow and prolonged. Such recessions tend to follow periods of rapid credit growth, involving overheated goods and labor markets, housing booms, and a loss of international competitiveness. Rapid credit growth often results in low household savings rates and a deterioration in household balance sheets. After the credit bubble bursts, a long period of retrenchment ensues. Demand remains weak, especially in areas of the economy dependent on credit, like residential and business investment.
Recessions that are highly synchronized across countries are likewise deeper and longer lasting than other recessions. When a good portion of the globe is in recession, exports cannot provide a way out, and hence recoveries are slow and protracted. The IMF found that highly synchronized global recessions typically followed or coincided with recessions in the United States. When the U.S. sneezes, the rest of the world catches cold.
Combine a global recession with a financial crisis, as is currently the case, and you have the worst of all possible situations. The current global contraction is deep and the recovery will be drawn out.
The IMF also compared the effectiveness of monetary and fiscal policies in recessions associated with financial crises to economic contractions triggered by other events. In recessions not associated with financial crises, expansionary monetary policies shortened the duration of the downturn and promoted faster recoveries, but fiscal policies have no noticeable effect. During recessions associated with a financial crisis, however, monetary policy, which operates mainly through banks and interest rates, is ineffectual, while fiscal policy gains some bite. That said, the effectiveness of fiscal policies wane rapidly during the recovery phase in countries saddled with high levels of public debt.