Not all recessions are alike. Unfortunately, many economists, politicians and members of the general public continue to act as if they are. If the only result of this were disappointment, it would not be so bad. But when governments, businesses and individuals make decisions based on faulty appraisals of the situations in which they find themselves, resources get wasted and the nation gets fewer of its people’s needs and wants satisfied.
We are in a recession right now, regardless of what any official committee says, that is unlike any we have been in before. Assuming that what happened in other recessions over the past 65 years will also happen now is not just unreliable, but treacherous.
This is particularly relevant for three reasons. First, it is becoming evident to many that returning to a recession strictly defined – that is, a prolonged period of falling output – is not only possible, but likely. Second, we are at the fourth anniversary of the visible onset of the financial crisis that touched off the recession and that continues underneath like a malignant tumor. Third, while four years may seem like a long time, history indicates we may not be halfway through the tunnel yet.
Start by understanding the different ways in which recessions can begin.
Some result from “exogenous shocks,” or events outside the economic system itself. The Sept. 11, 2001, attacks slowed important sectors of the U.S. economy, especially air travel. Even though the National Bureau of Economic Research maintains that a recession that had already begun in March that year ended only two months after 9/11, the economy remained sluggish.
The outbreak of war in August 1914 similarly threw many European economies for a loop, even though some would later experience booms producing war materiel.
Other recessions begin when a central bank acts to ward off looming inflation by crimping down on the money supply, thus raising interest rates. This is the most common immediate cause of recessions and is typified by the back-to-back ones that started after Paul Volcker took over as chair of the Federal Reserve Board in October 1979.
Many others start when an economy simply runs out of steam after a long period of growth, whether slow or fast. This is the core of the business cycle that has been observed for centuries. These recessions result, at least in part, from the extended period of prosperity lulling both entrepreneurs and lenders into a sense of unjustified optimism about deals they contemplate. Eventually, such wishful thinking increasingly moves resources to bad initiatives that, when they turn out rotten, push the economy into a slack period.
While not a rule, it is often true that the more extreme the rate of growth, the harsher the contraction. But such garden-variety recessions don’t necessarily involve widespread failures of banks and other financial institutions except as they are forced to write off bad loans. They don’t stem from systemic faults in the financial sector and are among the most amenable to amelioration with Keynesian fiscal and monetary stimulus efforts.
Some recessions do break out when there is widespread rottenness in financial institutions. These often are the most severe and the longest in duration of any recessions. There have only been three or four such incidents in our country over the 160 years examined by the NBER’s official Business Cycle Dating Committee: one starting in 1873, another perhaps in 1907, the great stock market crash of 1929 and the most recent one that began 2007.
These recessions that stem from financial crises, whether here or abroad, are the least amenable to fiscal and monetary efforts, largely because the underlying problems are so severe and affect such vital parts of an economy. Ken Rogoff and Carmen Reinhart examined 800 years of such financial crises in their influential book, “This Time Is Different,” and note that it commonly takes seven to 10 years for an economy to recover.
Don’t rely on that average, however, to predict specifically how long the current travail will last. Circumstances vary. That a dominant economic power, one that issues the currency used as a reserve by all the rest of the world, works itself into a debacle like the one we are in is rare indeed. There just are not enough cases remotely comparable to make any inferences from history to our current situation. But we are a long way from being through this.
Compound these difficulties with Europe’s problems and with China having been in a prolonged period of nearly unprecedented growth, and thus is overdue for major slowing. Then consider the debt that overhangs households as well as government. The road to recovery will be long and anyone, especially a politician, who tells you otherwise, is lying to you or is hopelessly naïve.
This matters because misunderstandings about what is likely or even possible exacerbate a climate of extreme uncertainty. In particular, happy talk by officials who think we are in a garden-variety business cycle recession confuses the public, which senses the dissonance between such talk and widespread anxiety over the unknowns we face. Uncertainty and perceptions that experts and officials are disconnected with reality breeds more fear and discourages investment and new initiatives. Fearful individuals and business managers may cut spending and thus save more, but this occurs at a time when lack of effective demand is keeping unemployment at painful levels, and the money saved is not channeled to other productive uses.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.