DeLong´s “Anatomy of a Slow Recovery”

According to DeLong:

The obvious hypothesis to explain why the current US recovery – like the previous two – has proceeded at a sub-par pace is that the speed of any recovery is linked to what caused the downturn. A pre-1990 recession was triggered by a Fed decision to switch policy from business-as-usual to inflation-fighting. The Fed would then cause a liquidity squeeze and so distort asset prices as to make much construction, sizable amounts of other investment, and some consumption goods unaffordable (and thus unprofitable to produce). The resulting excess supply of goods, services, and labor would cause inflation to fall.

This “anatomy” analysis is not new. After the 1990/91 recession there were also “concerns” about the changing nature of the recovery process.

For example, in the summer 1992 issue of Challenge Magazine, Robert Brusca, chief economist at The Nikko Securities Co., wrote a long piece titled Recession or Recovery?

“… by all historical standards there should be a strong recovery (following the 1990/91 recession). But the economy is now so uncertain, we could be in for a triple-dip recession rather than a recovery…” and there follows several pages of comparative statistics on the behavior of all kinds of economic variables following a recession, with the conclusion being that since the economy had not yet shown the strong rebound that historically follows a recession, his view was that the recession had not yet ended, “appearing to be the longest since the Great Depression” (at about the time the article was published, the official date for the end of the recession was put at March 1991).

Also, in the Fall 1992 issue of The Federal Reserve Bank of Minneapolis Quarterly Review, David Runkle (a senior economist in the research department) wrote: “… the current recovery is the weakest in the post war period in all measures of economic activity. This means that the current recovery is most appropriately viewed as a continuation of a long period of below average growth”.

The “this time is different” view is correct, but not for the reasons stated. Also, the “pathology” of the current situation is very different from the previous two.

The figures below provide a good illustration.

The first set of figures show real growth (RGDP) and nominal spending growth (NGDP) for two periods (1954 – 1983 and 1987 – 2007).

It´s straightforward to understand the worries shown by both Brusca and Runkle in the early 1990´s. By that time the growth process had changed, with the swings in economic activity – both nominal and real – becoming much more subdued. The recessions of 199/91 and 2001 are “short & shallow”, a pattern very different from what went on in the previous decades. Both the “busts” and the “booms” were much more contained. Trend real growth was essentially constant (around 3.3%) over the two stretches. But it is understandable that Brusca and Runkle should feel “frustrated” by the “weakness” of the recovery. Notable also is the relative stability of nominal spending growth from 1987 to 2007. During the 1950´s through the early 1980´s there is a clear rising trend in nominal spending. As the set of figures on inflation show, this imparted a growing trend to inflation, which disappears during 1987 – 2007. In this case, the “inflation-fighting” focus of the Fed is a “full-time concern” and not conducted by “switching on and switching off” the “control button”.

DeLong focuses on the unemployment rate. The next figures show the time series of unemployment for the same two periods. The rise in inflation ´that began in the late 1960´s is accompanied by rising and volatile unemployment. This volatility is greatly reduced during 1987 – 2007 and the fall in unemployment during this period shows similar persistence to that observed during the expansion of the 1960´s (from 1961 to 1969).

The important policy difference in the two periods is found in the growth of nominal spending, upward trending for most of the first period and evolving along a stable growth path in the second. In essence this “strategy” helped contain the propagation of shocks, stabilizing both inflation (at a low level) and real growth.

So we arrive at the current predicament. It´s not a question of slow recovery but the almost complete absence of one. And why is that so? The figures below repeat the previous ones for the 2008 – 10 stretch.

Nominal spending growth was significantly negative (something that had not happened since events during the Great Depression). Real growth plunged deeper than at any time in the post war period and inflation almost disappeared. With the opening up of such a big “hole” there´s no way unemployment will not skyrocket.

Monetary policy did it and monetary policy can pull the economy back to a reasonable level path. But the “memory less” nature of inflation targeting constrains appropriate actions by the Fed so the most we can expect is a very slow crawl back to a “place which will still be short of where we once were”.