From Great Recession to Resilient Recovery

The Great Recession was a deep downturn, but not as bad as the Great Depression of 1929. Rather, it was similar in size to the recession of 1974. A column by Fabrizio Zilibotti.

«A concern is that distrust for science and experts is feeding misguided policies.»

Eleven years ago, Western economies entered a deep recession. According to the Treasury Department, the total lost household wealth was 19.2 trillion $ and 8.8 million jobs were lost in the US. Unemployment soared across the board. In Europe, financial instability spread to sovereign debt markets causing massive tensions and bail-outs. The collective perception took on apocalyptic notes: «This time is different,» «Nothing will ever be the same again.» Some argued that an era had come to an end: the Harvard economist Larry Summers revamped the notion (coined in 1938 by Alvin Hansen and largely refuted by the data of posterior years) of «secular stagnation.» After two centuries of sustained economic growth… the fun is over.

Speaking to a group of business leaders in Sankt Moritz, I dared discuss scenarios with different speeds of recovery. The reaction of the audience was blunt. «Recovery? You really think we’ll see growth again!» were looking at each other in disbelief. Time for economists to eat humble pie and admit their failure. To some social scientists, it was the day of nemesis. It was time to finally deliver a decisive blow to the dismal science.

A market for «new thinkers» developed quickly – there was money on the table. Nouriel Roubini, who had had warned about the risk of financial instability, became a movie star. The success of few led to the proliferation of catastrophists who filled the debate with visions of new imminent economic misfortunes, from second-stage financial crises that would wipe out capitalism to the economic collapse of China. Institutes of new economic thinking proliferated around the world proposing creative arguments whose scientific solidity compares unfavorably with those of the Flat Earth Society.

It is not possible to predict when shocks hit

It would be fun to hold this crowd of new thinkers (including my friend Nouriel Roubini) accountable for the gloomy «forecasts» they made over the decade. Their prognoses remind me of my beloved grandmother (who died few years ago at the age of 102) who believed to have a sixth sense for predicting rainfall. «In three days, it is going to rains» – she would earnestly say without paying any attention to the scientific weather forecasts. Whenever I held her accountable to her prophecies («You said it would be rain today, yet it is sunny and dry…») she would just say: «Oh, be patient young man, you’ll see how it is going to rain…». And she was right, sooner or later it would rain. Her victorious smile would welcome me on the first rainy day.

People make sometimes fun of mainstream economists for their inability to foresee economic crises. Yet, according to economic theories, the onsets of economic fluctuations are unpredictable. According to state-of-the-art economic theory, economies are subject to periodical fluctuations triggered by shocks that can come from productivity (temporary accelerations and slowdown of technological progress) or demand (including, among other things, what my former colleague Marios Angeletos calls «sentiments»). All serious macroeconomists – be they of neoclassical or of Keynesian school – share a common view: it is not possible to predict when these shocks hit. If we could predict the occurrence of a crisis in two months, people would adjust their expectations and behavior right away, and everything would occur now, not in two months. Recessions are by definition unexpected events.

But, then, isn’t economics altogether useless? No, for at least two reasons. First, we can help identify risk factors that affect economic stability. Our awareness about the importance of different factors changes over time as new evidence accumulates. The importance of deleveraging – a key factor in the recent – was insufficiently appreciated by macroeconomists. The unfolding of the crisis made us collectively rethink and update our knowledge about these issues, like the oil crisis of the 1970s led us to reconsider the role of policy responses after supply-side shocks. Yet, our understanding will never surge to the level of making safe predictions. To draw a parallel, obesity predict cardiovascular diseases, but it is hard to say when problems will arise, and many obese people will actually never suffer from severe blood problems.

Employment rates back at pre-crisis levels

Second, economics can help us understand the mechanics of the crisis. We know, for instance, that after a negative shock employment recovers only slowly, and this may guide policies to help jobless people. We also know that recessions have not only bad consequences. The economist Ricardo Caballero from MIT coined in the 1990s the notion of cleansing effects of recessions: the worse firms exit and the better firms enter. Recessions trigger a churning of firms whose effect on innovation and long-run growth are reinvigorating. Bailing out bad firms and sectors comes at a high cost.

A decade or so after the start of the Great Recession, can we conclude that «this time was different?» By and large, no. Surely, we have been through a deep downturn, which caused a lot of pain. Yet, it was not as bad as the Great Depression of 1929, with which it was repeatedly (and misleadingly) compared. It was similar in size (in spite of the different causes) to the recession of 1974. Postrecession recovery was slow, but is also proving resilient. The US economy keeps doing well. China has slowed down compared with the first decade of the millennium. Yet, this is what was reasonable to expect (for reasons I analyze in detail in my presidential address of the 2014 annual meeting of European Economic Association). Overall, the Chinese growth performance continues to be very strong. For the first time in decades, a number of African countries including highly populated economies like Ethiopia, Nigeria, Kenya, Uganda, and Tanzania are growing fast, raising the hope of a sharp decline in extreme poverty. European countries are very diverse, granted, but at least in Central and Northern Europe growth has been solid albeit not stellar. Employment rates are back almost everywhere at the pre-crisis levels. Stock markets are at their historical maxima.

Monetary policy too careless

Is it then time for unconditional optimism? Would it be right to say again that «this time is different,» in the sense that we won’t see any longer recessions and downturns? The answer is «no». Overreactions to short term changes and sudden swings are frequent in the public debate. Before embracing the Great Recession blues, we had witnessed the triumphant mood of the deregulation and the Great Moderation. Between 1991 and 2007, there were no recessions in the US with the exception of the brief episode of the dotcom bubble burst in 2001 (the situation was very different in Switzerland, that experienced a bad decade in the 1990s). This situation was exceptional relative to historical trends – in the period 1945-1991, there was an average of two recessions per decade.

A concern is that distrust for science and experts is feeding misguided policies. The threat of a largescale trade war is the first concern. Overly soft monetary policy is also a risky strategy. The US economy has a very low unemployment rate, with booming housing and asset prices. It is hard to see any economic rationale for reducing interest rates now. Even the expansionary measures announced by the ECB are controversial. We may repent of these lighthearted policies. When the recession hits for real, the monetary authorities may find themselves in the situation of the hiker who meets the grizzly bear just after having emptied the pepper spray can to scare away mosquitoes.