How The Economy Recovers

Right now, there’s a violent argument going on about what “shape” the recovery will be.  The prognostications can be divided into three basic camps:

  • A “W”, or “double-dip”.  Short, happy, suckers’ boom, followed by another bust.
  • “Square root-shaped.”  Short, happy boom followed by years of doldrums a la Japan.
  • “V-shaped.”  Off to the races, fools.

(Those who as recently as three months ago were predicting another six months of hell have gone silent.  Understandably.)

The proponents of each particular recovery shape invoke carefully selected facts to back up their bloviating.  In order to better evaluate these facts (and the underlying arguments), it helps to review a bit of history.

Specifically, how does the economy usually recover?

Thanks to Asha Bangalore of Northern Trust, we have the answer.

This chart shows the economy’s performance in the four quarters following the start of recovery (the “first quarter” of recovery is the quarter containing the month that NBER pinpointed as the resumption of growth).  The bottom line is that recoveries are usually very sharp–GDP growth of 7%-8% for several quarters after the bottom.  The exception has been the last two recoveries, which were much slower.  We’ll discuss those below.

So, which kind of recovery is this going to be?

Here’s Asha’s take:

Real gross domestic product (GDP) is nearly certain to post an increase starting in the third quarter of 2009. Although each economic recession and recovery is different, it is nonetheless instructive to track the trail of economic history. The economic expansions which began in March 1991 and November of 2001 have been coined as “jobless recoveries” and it is entirely conceivable that the current recovery will join this humble group.

The median and average growth rates of real GDP during each of the first four quarters after the onset of a recovery are listed in table 1 excluding the 1991 and 2001 expansions. Two important conclusions emerge from table 1:

(1). Real GDP has posted a decline in the first quarter of an economic recovery in a few business cycles.

(2). The median and average growth of real GDP in the second, third, and fourth quarters
following the trough is stellar in all post-war economic recoveries excluding the 1991 and 2001
business expansions.
Consistent with the moniker of jobless recoveries, the 1991 and 2001
recoveries are marked with significantly tepid growth in the first four quarters after the trough. Based on history, the current projected jobless recovery could be a period of lackluster growth. The challenging credit market situation raises the probability of this forecast being accurate. The economic bulls may have to reconsider their forecasts. 

On the other side, meanwhile, is Jeff Matthews of RAM Partners, who we had on TechTicker this morning.  Jeff argued that the shape of the recovery mirrors the shape of the decline.  The last two recessions had shallow recoveries, he said, because the declines were shallow.  Our current recession, meanwhile, had a very sharp decline, so the recovery will be equally sharp.

Jeff sounded persuasive, as always, but we’re going to have to do some more factual work to evaluate that particular bloviating.  Back with more soon…

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