Notes from the Vault
The Financial Crisis and Recovery: Why so Slow?
Gerald P. Dwyer and James R. Lothian
The extremely slow pace of the recovery in the U.S. economy since the financial crisis of 2007–2008 is evident in many measures of economic activity. According to some observers, such weakness is to be expected. It is, they argue, a typical aftereffect of a financial crisis, a conclusion based on evidence derived from a quite varied group of countries (Reinhart and Rogoff 2011). Do U.S. data support this conjecture? That is the question we consider here.
The recent recession versus earlier ones
Rising unemployment is a serious aspect of recessions, and falling unemployment with improving prospects for employment are an important part of recoveries. Charts 1 and 2 show the U.S. civilian employment rate and total civilian employment. Judging by these measures, the current U.S. recovery is atypical and very weak compared to other post World War II recoveries. As chart 1 indicates, the unemployment rate has remained persistently high since the recession, persistent in a way that did not occur in any other recession since World War II.1 And as chart 2 indicates, employment has leveled off since the recession instead of resuming its typical, continued rise.
The data are for the civilian unemployment rate in the United States. The bars indicate recessions. The data are from the Bureau of Labor Statistics and Haver Analytics. The dates of recessions are from the National Bureau of Economic Research.
The data are for civilian employment of those aged 16 and over in the United States. The bars indicate recessions. The data are from the Bureau of Labor Statistics and Haver Analytics. The dates of recessions are from the National Bureau of Economic Research.
Table 1 provides a more precise view of the difference between the most recent recession and other recessions. Table 1 illustrates employment growth after all the recessions since World War II. It shows employment growth from when it peaked around the starts of the recessions and in the periods that followed, ranging from one year to almost four years. The longest period with lower employment is from the start of the recent recession in December 2007 until September 2011.
Peak employment is the maximum employment at the start of the recession or within one month of its start. Employment data are civilian employment of those aged 16 or over from the Bureau of Labor Statistics. The recession dates are from the National Bureau of Economic Research. The data end in September 2011.
The recent recession was unusually long—the longest since World War II—lasting 18 months. The average recession has lasted a little more than 10 months. Nonetheless, the recent recession is still not much longer than two previous recessions since World War II. Both the recession that started in November 1973 and the one that started in July 1981 were only two months shorter than the recent one.2
The employment decline in this recession, though, is extraordinarily severe and persistent compared to the declines in all of the other recessions since World War II. The employment decline is 5.2 percentage points three years after the start of the recession and 4.5 percentage points almost four years later.
This atypical behavior is reflected in the best measure of aggregate economic activity in the United States, real gross domestic product (GDP). As of the second quarter of 2011, real GDP has yet to return to its peak level in the second quarter of 2008.
Table 2 shows how extraordinary this persistently low real GDP is, similar to the way in which table 1 shows the change in employment. The recession from the fourth quarter of 2007 to the second quarter of 2009 is the only one since World War II in which real GDP is below its value at the cycle peak so long after the peak. In the second quarter of 2011—14 quarters after the cycle peak—GDP was still 0.4 percentage point lower than at the start of the recession.
Peak GDP is the maximum GDP at the start of the recession or within one-quarter of its start. The GDP data are from the Bureau of Economic Analysis at the Department of Commerce and the recession dates are from the National Bureau of Economic Research. The data end in the second quarter of 2011.
This recovery of real GDP stands in sharp contrast to those registered after the other 10 recessions since World War II. On average, real GDP is 10.5 percentage points higher 14 quarters after reaching its peak at the start of the recession. The increases in real GDP range from 4.9 to 18.7 percentage points, far different from the -0.4 percentage point in this recovery.
This continued lower employment and real GDP are even more inconsistent with previous U.S. experience than these comparisons indicate. "Zarnowitz's rule" (1981) posits that deep recessions generally are followed by steep recoveries. But as expressed earlier, our recent experience is quite different—a deep recession followed by a flat recovery.
Explanations for slow growth
Tables 1 and 2 show that one explanation for this lower employment and higher unemployment—the increased productivity of those employed—is not sufficient by itself to explain the employment picture. While those who are employed may well be more productive, real GDP has not even recovered to its level at the start of the recession.
It might seem that the length of the recession itself could explain the employment decrease, but the tables indicate otherwise. For instance, the longest recessions in tables 1 and 2 other than the most recent one are those in 1973 and 1981. For those recessions, employment is 7.7 and 6.2 percentage points, respectively, higher three years and 10 months after the recessions started, while real GDP is 8.1 and 11.8 percentage points higher. For the most recent recession, in contrast, employment is 4.5 percentage points lower and real GDP 0.4 percentage point lower.
No U.S. recession since World War II has been associated with a financial crisis. Perhaps, as some have argued, the financial crisis and its aftereffects account for the difference between this recovery and earlier ones? Reinhart and Rogoff (2009), for example, make this argument. After examining a variety of financial crises in other countries since World War II, they conclude that
"[t]he unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years."
The recent increase in the U.S. unemployment rate is not that large, although the duration of the elevated unemployment rate is likely to be longer.
Reinhart and Rogoff base their conclusion on data for five crises since World War II in Western Europe and Japan as well as eight emerging-market crises. Some of these economies, however, are quite different from the U.S. economy. That, in turn, raises concerns about the ability to generalize from these countries to the United States.
While the United States has not had a financial crisis since World War II besides the one in 2007 and 2008, it certainly experienced a number of financial crises before then. Does this earlier U.S. experience support the conclusion that financial crises are associated with long periods of reduced employment and real GDP?
Table 3 shows the cumulative quarterly increases and decreases in real gross national product (GNP) in the six U.S. recessions with crises, in the two severe U.S. contractions with no crisis, and in the recent crisis and recession.3 Chart 3 shows these same data. The increases in real GNP two years after the end of the recession are greater in most instances than the decreases in GNP during the recession. The two severe recessions without crises—in 1920 and 1937—look indistinguishable in chart 3 from the other recessions.
The expansion data are for eight quarters following the cycle trough. The data end in the second quarter of 2011. The classification of cycles follows Cagan (1965). The real GNP data are from Balke and Gordon (1986) for the period from 1875 to 1946 and from the Bureau of Economic Analysis thereafter. The recession dates are from the National Bureau of Economic Research.
The data are from Table 3. The horizontal axis shows the fall in real GNP during the contraction. A -15 percentage point change in real GNP during the contraction is shown as +15 percentage points on the horizontal axis. The National Bureau of Economic Research often discusses "recessions" in terms of "contractions" in economic activity, and that term is used here. The 45-degree line shows equal growth rates of real GNP during contractions and expansions. Points on the 45-degree line indicate growth of real GNP in the expansion equal to the decrease in real GNP in the contraction. Points above the 45-degree line indicate growth of real GNP in the expansion greater than the decrease in real GNP during the contraction.
The Great Depression and the recent recession stand out, though, both having increases in real GNP of about the same magnitude as the decreases. All the other recessions have increases noticeably greater than the decreases, indicating that the economy expanded more in the first two years after the end of the recession than it decreased during the recession.
In five of the six historical crises—the Great Depression is the lone exception—the strength of the recovery in real GNP exceeded the previous decline by a substantial amount, close to 6 percentage points, on average.4 That is, moreover, roughly similar to what we see in the two severe contractions in which there were no financial crises. The recent recession and recovery seem more similar to the Great Depression than the other episodes.
Explanations for our current sluggish recovery also echo those of the Great Depression. One argument is low aggregate demand due to insufficient stimulus by monetary and fiscal policy (Krugman 2010). Another argument is continued uncertainty about economic policy (Pirrong 2011; Becker 2011).
It is not simple to test alternative theories tailored to fit the data for one observation—recent U.S. experience—but the extraordinarily long recovery after the economic contraction from 1929 to 1933 provides some additional evidence. Economic activity was depressed from 1929 to 1941, at least judging by the unemployment rate and similar economic measures. The recovery after 1933 is so long that the eight years after the contraction plus the years 1929 to 1933 are often considered to be one long episode of low economic activity, the Great Depression of 1929 to 1941.
Low aggregate demand is a prominent explanation of the Great Depression, and it's notable that Keynesian economic theory was articulated during that time. More recently, Cole and Ohanian (2004) and Kehoe and Prescott (2007) suggest government policies that reduce output and employment are more important in prolonging depressed economic conditions. This recent literature is related to prior literature on uncertainty, government policy, and the Great Depression (Roose 1954, pp. 45–47; Higgs 1997). No doubt the coming years will see detailed examinations of the importance of uncertainty and government policies compared to aggregate demand in the most recent recovery. A divide between those who put their stock in these alternative explanations is likely to persist, just as it has for the Great Depression.
The U.S. economy has only very slowly recovered from the recession of 2007 to 2009. U.S. history provides no support for an explanation based on the financial crisis itself, although data on financial crises in some other countries appear to do so. The recent slow recovery is most similar to the Great Depression. Low aggregate demand for reasons unrelated to the financial crisis may be an explanation for both episodes, but uncertainty and government policies are an alternative supported by recent research on the Great Depression.
Gerald P. Dwyer is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. James R. Lothian is distinguished professor of finance at Fordham University and visiting professor, Tilburg University. The authors thank Thomas Cunningham for helpful comments on the paper. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
1 Additional data on employment, the unemployment rate, and real gross domestic product were released while this note was being completed. None of the numbers changes the picture in this note. The unemployment rate fell from 9.1 percent to 9 percent. The advance estimate of real GDP for the third quarter indicated growth at a rate of 2.5 percent per year, leaving real GDP a scant 0.2 percentage point above its peak nearly four years earlier.
2 The recessions in this table are dated by the National Bureau of Economic Research's Business Cycle Dating Committee and are not determined in an automatic way by the behavior of data series. "Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales" (NBER 2011).
3 Historical data typically are based on gross national product. Gross domestic product only came into widespread use in the United States in recent decades.
4 Bordo and Haubrich (2011) provide additional evidence.
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