IMFSurvey Magazine: IMF Research
WORLD ECONOMIC OUTLOOK
Global Recession to Be Long, Deep with Slow Recovery
By Marco E. Terrones, Alasdair Scott, and Prakash Kannan
IMF Research Department
April 16, 2009
- Recessions associated with financial crises are typically severe, long lasting
- Synchronized recessions have similar features, limited recovery role for exports
- Countercyclical policies effective in shortening recessions, firming recoveries
Two features of the current recession—its association with deep financial crisis and its highly synchronized nature—suggest that it is likely to be unusually severe and followed by a slow recovery, according to new IMF research.
However, macroeconomic policies can cushion the blows to incomes.
The research, published as Chapter 3 in the April 2009 World Economic Outlook (WEO), finds that recessions that are either associated with financial crises or that are highly synchronized worldwide have historically been longer and deeper, and featured weak recoveries (see chart). The combination of these two features—a rare phenomenon in the postwar period—resulted in even costlier recessions, which lasted almost two years.
The research also finds that countercyclical policies have played an important role in ending recessions and strengthening recoveries. In particular, fiscal policy appears to be especially helpful during recessions associated with financial crises. The impact of fiscal policy on the strength of recovery, however, is weaker for economies that have high levels of public debt.
Recessions and expansions
The study examines the dynamics of business cycles in 21 advanced economies over the past half century. A total of 122 recessions were identified in the sample. Recessions are distinctly shallower, briefer, and less frequent than expansions, reflecting in part the importance of trend growth.
Some recessions, however, are severe, with peak-to-trough declines in output exceeding 10 percent. These episodes are often called depressions. Since 1960, there have been six depression episodes in the advanced economies; the latest was observed in Finland in the early 1990s.
Recessions and financial crises
The study goes on to determine whether there have been important differences between the recessions associated with financial crises and the others. Using the dates of financial crises, a recession is said to be associated with a financial crisis if the recession starts at the same time or after the beginning of a financial crisis.
Of the 122 recessions, 15 are associated with financial crises. Recessions associated with financial crises are longer and generally more costly than others. They are also followed by weak recoveries: the time taken to recover to the level of activity reached in the previous peak is as long as the recession itself, whereas cumulative GDP growth in the four quarters after the trough is typically lower than following other types of recessions.
Why are financial crises different? Evidence indicates that the expansions that preceded these recessions have often been associated with credit and house price booms involving overheated goods and labor markets and, frequently, a loss of external competitiveness.
The rapid growth in credit, oftentimes following financial deregulation, typically leads to a deterioration in the quality of balance sheets. The turnaround in household savings behavior—in an attempt to restore their balance sheets—leads to sharp declines in consumption, which persist through the recovery phase.
Highly synchronized recessions
The global nature of the current downturn begs the question of whether the synchronization of recessions across countries affects the recession and subsequent recovery. To address this issue, the study looks at episodes of highly synchronized recessions, defined as those where 10 or more countries were simultaneously in recession.
In addition to the current cycle, there were three other episodes of highly synchronized recessions: 1975, 1980, and 1992. These recessions were on average longer and deeper. Distinct from other episodes, the recoveries from these recessions feature much weaker export growth, especially if the United States is also in recession.
A perfect storm? Recessions that are associated with both financial crises and global downturns have been unusually severe and long lasting. Since 1960, there have been only six recessions out of the 122 in the sample that fit this description: Finland (1990), France (1992), Germany (1980), Greece (1992), Italy (1992), and Sweden (1990). On average, these recessions lasted some two years, were unusually severe, and featured weaker-than-average recoveries.
Role of countercyclical policies
The shapes of recessions and recoveries are potentially influenced by policymakers’ attempts to reduce the severity of the recession. Across all types of recession, there is evidence that expansionary monetary policy is typically associated with shorter downturns, whereas expansionary fiscal policy is not.
However, during recessions associated with financial crises, fiscal policy tends to have a more significant impact, which is consistent with other studies that find that fiscal policy is more effective when economic agents face tighter liquidity constraints. The lack of a statistically significant effect from monetary policy during financial crises could be a result of the stress experienced by the financial sector, which hampers the effectiveness of the interest-rate and bank-lending channels of the transmission mechanism of monetary policy.
Results presented in the study also find that both fiscal and monetary expansions undertaken during the recession are associated with stronger recoveries. However, concerns about fiscal sustainability can detract from the effectiveness of fiscal stimulus during recoveries..
Lessons for current recessions
As this article is being written, 15 of the 21 advanced economies included in this study are already in recession. There are clear signs that, consistent with previous experience of financial stress, these recessions are already more severe and longer than usual.
The results of this study suggest that, in order to mitigate the severity of the current recession and to strengthen the recovery, aggressive monetary and particularly fiscal measures are needed to support aggregate demand in the short term, though care must be taken to preserve public debt sustainability over the medium run.
Furthermore, given the global nature of the current recession, fiscal stimulus should be provided by a broad range of countries with fiscal room to do so, so as to maximize the short-term impact on global economic activity. Even with such measures, one of the most important lessons from episodes of financial crises is that restoring confidence in the financial sector is the key condition for a durable recovery to take hold.
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