The worst recovery in history

6th April 2012

Following one of the best quarters for equities for years, investor optimism is back on the agenda. There is plenty of talk of the dark days of 2007-08 and the subsequent slump in trade disappearing into the past. And while few are forecasting a boom, the word "slump" has been expunged from the financial lexicon.

Economists talk of the recovery from the crisis taking the same shape as in previous set backs over the past six or seven decades. In other words, they expect the path upwards to be similar to that in other recessions. And many investors are only too happy to confirm their "optimism bias" by buying into equity markets.

It may be time to reframe the argument as not all economists are so cheerful. Some suggest that the recovery from the deepest financial crisis since 1929 – in the UK for far longer than that – will not and cannot take on the normal shape. 

While history is no guide to the future, it's worth pointing out that the US stock market did not hit rock bottom until 1932. Between the October 1929 crash and that date three years later, there were several false dawns. It took a world war – in itself partly caused by the financial crash – and its economic activity to bring the developed world and stock markets back to the brightness that lasted more than half a century.

US economists Greg Howard, Robert Martin and Beth Anne Wilson have suggested that recoveries from financial crises might not be as different from the aftermath of conventional recessions. In a paper "Are Recoveries from Banking and Financial Crises Really So Different?"  they study the behaviour of recoveries from recessions across 59 advanced and emerging market economies over the past 40 years.

Advocates of recovery

They say: "Focusing specifically on the performance of output after the recession trough, we find little or no difference in the pace of output growth across types of recessions. In particular, banking and financial crisis do not affect the strength of the economic rebound, although these recessions are more severe, implying a sizable output loss. However, recovery does change with some characteristics of recession. Recoveries tend to be faster following deeper recessions, especially in emerging markets, and tend to be slower following long recessions."

But this optimism is refuted by economists Carmen M. Reinhart and Kenneth S.Rogoff in a Bloomberg article.

They say the business as usual case is "unconvincing".  They add: "It is mystifying that they (Howard, Martin and Wilson) can make this claim almost five years after the subprime mortgage crisis erupted in the summer of 2007 and against a backdrop of an 8.3 percent unemployment rate (compared with 4.4 percent at the outset of the financial crisis). Our research makes the point that the aftermaths of severe financial crises are characterized by long, deep recessions in which crucial indicators such as unemployment and housing prices take far longer to hit bottom than they would after a normal recession. And the bottom is much deeper."

Redrawing the road back

Reinhart and Rogoff believe "the concepts of recession and recovery need to take on new meaning. After a normal recession (which for the average post-World War II experience in the U.S. lasted less than a year), the economy quickly snaps back; within a year or two, it not only recovers lost ground but also returns to trend. After systemic financial crises, however, economies of the postwar era have needed an average of four and half years just to reach the same per capita gross domestic product they had when the crisis started.  With the Great Depression of the 1930s, economies on average needed more than a full decade to regain the initial per capita GDP."

The duo attack the "it will be different this time" line.

They say: "We admit that this time is different in one important respect: The goal posts many analysts use to assess economic outcomes seem to shift from data point to data point. When we first identified that financial crises were associated with severe recessions, the rosy-scenario crowd responded that the Great Moderation had smoothed the business cycle. 

"Recessions in the new era were short and shallow. After the crushing contraction, a new metaphor held that the harder the fall, the more vigorous the bounce back. Nonetheless, what followed was an anemic recovery that has yet to pull per capita annual real GDP back to the level of 2008."

The jury is out on hope

"Looking ahead, does history suggest that the current U.S. recovery will be strong and robust, even if it has been so long coming? We hope this will be the case, but the jury is out."

They are supported by economist Edward Lazear, a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow. He says "this is the worst economic recovery in history".

Comparing now with 1929

He says: Less publicised is that our current recovery pales in comparison with most other recoveries, including the one following the Great Depression.

The Great Depression started with major economic contractions in 1930, '31, '32 and '33. In the three following years, the economy rebounded strongly with growth rates of 11%, 9% and 13%, respectively.

The current recovery began in the second half of 2009, but economic growth has been weak. Growth in 2010 was 3% and in 2011 it was 1.7%. Who knows what 2012 will bring, but the current growth rate looks to be about 2%, according to the consensus of economists recently polled by Blue Chip Economic Indicators. Sadly, we have never really recovered from the recession. The economy has not even returned to its long-term growth rate and is certainly not making up for lost ground. No doubt, there are favourable economic numbers to be found, but overall we continue to struggle."

He adds: "Contrast our weak growth with the recovery that followed the other large recession of recent decades. In the early 1980s, the eco
nomy experienced a double-dip recession, with contractions in both 1980 and '82. But growth rates in the subsequent two years averaged almost 6%." This has not happened this time.


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