Recessions, the Output Gap and Central Banks

A recent paper by the Federal Reserve looks at the impact of the global financial crisis on the economic recovery in many of the key economies of the world and whether the impact of major crises on economic output is temporary or permanent.   This issue is particularly pertinent, given that the recovery since the Great Recession has been far weaker than what would normally be expected, particularly given the massive doses of monetary policy that the world's key central bankers have injected into their respective economies.

Here is a graphic showing the projected GDP trend (in dashed black) using the growth rate from the fourth quarter of 2007  and the actual GDP in red since the Great Recession for the United States, United Kingdom, Euro-area and Canada:

You'll notice that in each case, post-Great Recession GDP has fallen well short of where it would have been had the economy continued to grow at pre-Great Recession rates (the gap between the dashed black line and the red line).  This could be termed an "output gap".

Here are the actual GDP/output gaps for the early months of 2014:

Note that the largest gap is in the Eurozone where 15.9 percent of potential GDP has been shaved off, followed by the United Kingdom at 14.07 percent, the United States at 9.93 percent and Canada at a rather measly 4.92 percent.

The study goes on to look at all 149 recessions since 1970 for 23 advanced economies to see how growth rates compare after recessions.  Since the authors wish to measure the impact of both modest and severe recessions on economic growth, they exclude the Great Recession  which leaves 117 recessions   The authors calculate pre-recession trend growth as the four-year average growth rate for each country, two years prior to each peak and examine GDP as a percentage of this trend for each recession prior to the Great Recession.  By excluding the two years prior to a cyclic peak, the authors are able to exclude periods of potential "bubble-like" growth that may boost trend growth rates.

Here are their results:

The black line shows the level of real GDP as a percentage of its pre-recession trend around all 117 recessions, the blue line shows the level of real GDP as a percentage of its pre-recession trend for severe recessions and the blue line shows the level of real GDP as a percentage of its pre-recession trend for mild recessions.  On average, GDP remains well below the previous trend for both mild and severe recessions although the loss of output is greater for severe recessions.  You'll notice that the negative impact of even mild recessions on economic growth rates for even mild recessions appears to persist.  

Widely followed economic models have generally assumed that recession-induced output gaps will close over time because post-recession economies experience a period of above trend growth (i.e. there is a surge in economic activity, both output and demand for that output, that makes up for the lost activity during the recession that pushes the economy back to its long-term trend growth rates).   This suggests that recessions of all types, including those that are relatively mild, may have a permanent dampening effect on demand.  The research also shows us that the severity of the Great Recession on the global economy has resulted in a strong and permanently negative impact on demand that has depressed economic growth rates.  It would appear that, despite the unprecedented intercession of central banks and their monetary experiments, the global economy is highly unlikely to return to its pre-Great Recession growth rates anytime soon.  This is particularly concerning for Europe where economic growth rates look extremely anemic nearly six years after the end of the latest recession.

So much for trillions of dollars worth of quantitative easing and twisting!

Why This "Recovery" is Different

An article by M Ayhan Kose, Prakash Loungani and Marco Terrones, all of the IMF, on the VOX website examines why this global recovery is different and why, despite the fact that we are four years into the recovery, has it been so weak compared to past post-recession recovery periods.

As shown on this graph, global real per capita GDP growth after the Great Recession (in red) has followed a path that is very similar to the average of previous recoveries (in blue):

On the graph, global real per capita GDP is normalized to a level of 100 in the year before the recession.  On average, the world's economy has generally returned to its pre-recession level of output within a year of the end of the recession and this recession was no different on a global level.

Now, let's take a quick look at a graph showing GDP growth in the United States since 1990:

Notice that after the recession in the early 1990s and 2000s, that economic growth rates in excess of 5 percent were not uncommon.  Such is not the case since 2008 as shown here:

That noted, there is something different this time as shown on these graphs:

This time, the current recovery (in red) has been far different for advanced economies than it has been for emerging market economies with the economies of advanced nations being quite weak compared to both previous recoveries (in blue) and the recoveries of emerging nations.

Why the difference this time?

1.) Problems in the design of the single currency Eurozone.

2.) The severity of the financial crisis.

3.) The uncertainty of policies implemented by governments and central banks.

4.) The synchronized nature of the Great Recession across most major economies.

There are two additional factors at play that I will elaborate on.

First, government expenditures, used to stimulate moribund economies, in the advanced and emerging economies are very different this time as shown on these these graphs:

In the past, in advanced economies, government expenditures expanded and real government expenditures increased as governments prodded their economies back to life.  Not this time.  For example, even though the United States government pumped trillions of dollars of fiscal stimulus into the economy, this was done very early in the recession and fell thereafter.  In contrast, real expenditures in emerging market economies grew more rapidly than average.  This is largely because emerging market economies had stronger fiscal positions than their advanced economy counterparts.

Second, the governments of advanced economies have a far higher level of debt prior to and during the recession than in past recoveries, particularly when compared to their emerging market counterparts.  On top of that, the severity of the Great Recession meant that revenues collapsed, resulting in very high deficits and even higher debt levels.  Here are graphs that show how public debt-to-GDP levels are different this time for both economies:

Note that the public debt levels of emerging market economies are basically the same as they have been throughout previous economic cycles in contrast to advanced economies.

This time, unlike past post-recession periods, the governments of most of the world's largest economies have been unable to spend their way out of trouble.  It appears that the elevated level of public debt has finally caught up to us and that the world's economy has reached the point where it has to rely on central bank policies to bail it out.  Unfortunately, now that we're at the zero bound on interest rates, central bankers are having to rely on unconventional (read experimental) measures that may have unintended consequences over the long-term.  

Home Ownership and The Savings Rate: Their Impact on the Recovery

Many economists have spent a great deal of time trying to understand why, despite prodding from both the Federal government and Federal Reserve, the American economic "recovery" has been tepid at best.  In an article entitled "The Housing Trap" by Dr. Zinna Mukherjee, Research Fellow at the American Institute for Economic Research, the author explains how the upsurge in home ownership in America led to reduced savings rates and has ultimately led to a deepening of the Great Recession.

Let's take a look at the first factor that is affecting the economic recovery; America's personal savings rate.  Here's a graph showing the United States personal savings rate since 1950 from the St. Louis Fed:

You will notice that the savings rate peaked just after the mid-1970s recession at just under 15 percent and again, during the 1981- 1982 recession when it was more or less stable at around 12 percent.  The savings rate fell throughout the remainder of the 1980s and most of the 1990s and ranged between 2.5 and 4 percent.  It began dropping again in 2005, reaching a new low of 1.1percent.  It wasn't until the onset of the Great Contraction in 2008 that the savings rate rose to between 5 and 7 percent.  In its most recent data release, the Bureau of Economic Analysis data shows that the personal savings rate in January 2012 fell to 4.6 percent, down from 4.7 percent in the prior month.

For interest's sake, here is a graph showing the actual level of personal savings in billions of dollars:

You will notice right away that the number of dollars saved by Americans remained with in a relatively narrow band between 1980 and 2008, ranging from just over $130 billion to about $360 billion and that, despite the growth in the economy and population over the three decade period, Americans chose not to add to their personal savings.  That all changed in 2008 when total funds saved shot up to nearly $700 billion.

According to Dr. Mukherjee, over the thirty year period, the savings rate dropped for several reasons:

1.) The decline in interest rates on low-risk savings options such as Certificates of Deposit reduced the incentive for individuals to save.  Both nominal and real interest rates on such investments dropped with 6 month real rates dropping from 5.4 percent in 1981 to -1.2 percent in 2010.  This is actually the outcome that central bankers are looking for when lowering interest rates; the less you save, the more you spend and the more that the economy grows.

2.) The massive growth in stock values drove many more conservative investors into riskier equities and out of bank fixed income products.

3.) House price appreciation reduced savings; during the 1990s, every dollar increase in housing prices boosted spending by 15 cents in contrast to financial assets which saw an increase in spending of only 2 cents for every dollar increase in value.  The rise in the value of homes also impacted the savings rate; in some cases, the fall in savings was as high as 11 cents for every dollar increase in the value of a home.

Now, let's take a look at the second factor affecting the economic recovery; the rate of home ownership and how it interacted with the savings rate.  Here's a graph showing the rate of home ownership in the United States since the mid-1960s from the United States Census Bureau:

Here is a graph showing the rate of home ownership by region for the fourth quarter of 2011 from the United States Census Bureau:

Notice on the second last graph that home ownership levels rose from below 64 percent in the mid-1960s to its peak at 69.2 percent in 2004.  While it might not seem like a great increase, this is a large part of the reason why America's economy has not recovered since the Great Contraction.  The increase in the home ownership level in America was largely a result of government policies.  The Tax Reform Act of 1986 allowed for the continued deduction of home mortgage interest from personal taxes.  On top of that, home owners can also deduct local and state property taxes from their gross income.  As well, when a primary residence is sold at a profit, capital gains of up to $500,000 per couple are excluded from taxation.  Coincidentally, if you look back at the savings rate graph, you will notice that home ownership levels rose as the savings rate fell.  Government policies caused many Americans to view their homes not just as places to live, but as their source of wealth.  While many upper income earners had other assets that complimented their real estate investments, the same cannot be said for lower and middle income Americans.  This "wealth effect" of home ownership caused many Americans to divert their incomes toward home ownership rather than toward other forms of savings. 

Now, let's go back to Dr. Mukherjee's paper.  As I noted at the beginning of this posting, household savings rates had been in decline for the better part of 25 years, right up to the doorstep of the 2008 recession.  It makes common sense that if a recession follows a period of low savings that households will have to borrow additional funds to maintain their lifestyles.  With banks tightening their lending standards, this additional borrowing was not always possible.   In addition, as house prices fell, the wealth affect associated with home ownership disappeared.  For these two reasons, American households were forced to cut back on spending, resulting in an increase in the savings rate.  As I noted above, during the Great Recession, the savings rate rose from 2.4 percent to nearly 7 percent and the total dollars saved rose from $130 billion to just under $700 billion, a 500 percent increase.  The funds that normally would have entered the economy as consumer spending were saved instead, resulting in sluggish GDP and employment growth.

Let me summarize Dr. Mukherjee's thesis.  Prior to the Great Recession, the housing boom (i.e. increasing levels of home ownership along with ever-rising prices) and the affiliated ability of mortgage holders to withdraw equity resulted in elevated levels of spending and economic growth and depressed levels of saving.  Such was the case over the 25 years prior to 2008.  Once the Great Recession was entrenched, the wealth effect associated with home ownership disappeared along with consumers ability to borrow additional funds by using the modest equity in their homes as an ATM.  As a result, the personal savings rate rose during the recession and the total amount saved by American households rose 5 fold.  As well, outstanding consumer credit showed a decline as seen on this graph:

This saved money is withdrawn from the economy, consumption drops and, as a result, the economy is unable to grow; this is particularly noticeable because consumer spending now makes up roughly 70 percent of U.S. GDP.

To conclude, I concur with the author's suggestion that the tepid economic growth that we are now experiencing is related to both the collapse of the housing boom and the rise in savings, two factors that were interlocked in the period leading up to the Great Recession.  That said, there are many other factors that come into play when trying to explain why the so-called recovery has been unequally experienced by many Americans including the Federal Reserve's ultra-low interest rate policy, elevated government debt levels, an oversupply of over-priced housing and speculative investment in the housing market.  I suspect that the issues facing the American economy over the coming year will provide plenty of fodder for further analysis.