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Recession of 2009

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Supplements to this article include a glossary; links to reports of the major economic events in the fourth quarter of 2008 and each of the four quarters of 2009; tabulations of GDP growth rates, unemployment rates, public debt, total debt, and, fiscal stimulus packages

The recession of 2009 was the sequel to the financial crash of 2008 that led, in late 2008 and early 2009, to reductions in the growth rates of all of the world's emerging economies and to downturns in all of its mature economies - and that was to have major repercussions thereafter.

Introduction

This article is the third of a series of contemporary accounts of financial and economic events and developments during the period from mid 2007 to the end of 2011. The other articles are:-

Subprime mortgage crisis - events surrounding the bursting of a house price bubble in the United States in mid 2007;
Crash of 2008 - global financial developments from mid 2007 to the end of 2008;
Great Recession - an overview of global financial and economic events between mid 2007 and the end of 2011.

The downturn

Throughout the period from mid-2007 to mid-2008, the growth of the world economy was hampered by increases in oil and food prices, and by a crisis in the financial markets. Oil prices rose from $75 to $146 a barrel and food prices rose sharply, forcing householders to cut their spending on other products. On the financial markets, the subprime mortgage crisis developed into the crash of 2008, as a result of which the availability of credit to households and businesses was curtailed, leading to further reductions in household spending and business investment. In the nine months to the middle of 2008, the advanced economies had grown at an annual rate of only one per cent (compared with two and a half per cent in the previous nine months) and the growth rate of the developing economies had eased from eight per cent to seven and a half per cent. According to the OECD [1] the US economy was by then already facing substantial difficulties. Households had borrowed at an unprecedented rate during the previous 15 years, and their saving rates had fallen nearly to zero as they increasingly relied on housing wealth to finance consumption. With the housing market suffering the severest correction for 50 years, household wealth was declining, and with credit conditions getting tighter, households had been forced to reduce their reliance on borrowing, and job losses and mortgage foreclosures were rising.

The prospects of a recession in the United States and of substantial reductions in economic growth elsewhere were becoming apparent when the world economy was hit by another shock. The failure of the Lehman Brothers investment bank in September raised doubts about the creditworthiness of major global financial institutions, and the ensuing banking panic threatened a collapse of world’s financial system. Attempts by banks to restore their capital adequacy, resulted in capital hoarding, and the resulting liquidity shortage (or credit crunch) undermined consumer and business confidence, and triggered a further contraction in demand. Falls in demand, together with credit shortages led to a massive reduction in world trade.

Many industrialised and developing countries suffered reductions of economic activity. Economies with relatively large financial sectors - such as those of Britain and Iceland - suffered directly from the banking crisis. Economies with relatively large export sectors - such as those of Japan and Germany and many developing countries - suffered indirectly from the reduction in world trade. There were widespread increases in unemployment. Budget deficits grew during the downturn, mainly as a result of the operation of automatic stabilisers and, to a lesser extent, as a result of discretionary fiscal policy, and the levels of debt owed by the governments of the industrial governments were forecast to rise to an average of 120 percent of gdp by 2014.

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The policy response

Massive financial support to their banks in the closing months of 2008 by the governments of the industrialised countries averted a threatened collapse of the international financial system, but failed to restore the supply of credit to businesses and householders, and further action was taken to tackle the growing recession. In a departure from accepted practice, the governments of the G20 group of major economies agreed to use fiscal policy in order to stimulate demand by tax cuts and increases of public expenditure. Fiscal stimulus packages were adopted that amounted to 4.8 percent of GDP in the US, 3.4 percent in Germany, 1.5 percent in the UK and 1.3 percent in France. Supportive monetary policy action was also taken by the major central banks by making massive reductions in their discount rates, followed - in a further departure from accepted practice - by injections of liquidity into their economies, mainly by the purchase of securities from their private sectors (quantitative easing or credit easing[2]). The Federal Reserve Board reduced its discount rate to 0 to 0.25 percent and made security purchases amounting to 12 percent of GDP[3]; the Bank of England reduced its bank rate to 0.5 per cent and made asset purchases amounting to 6 percent of GDP[4].; and the European Central Bank reduced its discount rate to 1.0 percent and made asset purchases amounting to 0.6% of Eurozone GDP[5].

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The economic recovery

Although in purely technical terms the recession ended in most countries in the course of 2009, levels of activity remained substantially below normal levels and there was considerable uncertainty throughout the year about future prospects. In view of a continuing credit crunch, there were few expectations of an early return to pre-recession growth rates, and there were some fears of a long period of near-stagnation such as that suffered by Japan during the period 1990 to 2005. The American economist Paul Krugman argued that what happened in Japan may have been due to a reluctance to spend on the part of householders impoverished by collapses of housing and stock market bubbles[6], and the Japanese economist, Richard Koo applied the term "balance sheet recession" to a situation in which companies as well as householders reduce spending in order to repay debts and rebuild reserves[7]. Reports of increases in household saving ratios in the United States[8] and Britain[9] tended to add to those fears, but it has been argued that Japan's experience is unlikely to be repeated by the United States or the other indebted economies because their bubbles were proportionately smaller, their banks tend to be more profitable, and prompter action has been taken to recapitalise their banks[10].

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The policy debate

Overview

A conflict about fiscal policy developed towards the end of 2008 between those who feared that the proposed expansion would be insufficient to counter growing output gaps - and those who considered a fiscal stimulus to be unnecessary or ineffective. Among the first group were the Nobel prize-winners Paul Krugman [11], and Joseph Stiglitz [12]. Among the others were the Chicago School's Eugene Fama, and a group of eminent British economists who argued that "occasional slowdowns are natural and necessary features of a market economy" and that "insofar as they are to be managed at all, the best tools are monetary and not fiscal ones"[13]. Further controversy developed in the course of 2009 between those who favoured reductions in [national debt]] early in 2010 in order to avert fears of being forced into sovereign default, and those who advocated the continuation of fiscal expansion until the recovery was firmly established.

Fiscal policy

The consensus view

By October 2008, policy-makers in most industrialised countries had accepted that in order to avoid the development of persistent and unmanageable deflation such as occurred in the Great Depression, early corrective action would have to be taken, going beyond the necessary restoration of activity in the financial system. Most countries had long abandoned the use of reductions of taxation and increases in public expenditure to ward off economic downturns in favour of the use of monetary policy targeted on the output gap, but there were doubts whether monetary policy would be sufficiently powerful, or sufficiently quick-acting in view if the severity and imminence of the current deflationary threat. In the United States, in particular, the federal discount rate had already been reduced to 1 per cent - leaving little scope for further reductions, but banks there and elsewhere had become reluctant to pass on central bank reductions of interest rates. The consensus view among economists, as expressed by the Chief Economist of the OECD was that :

Against the backdrop of a deep economic downturn, additional macroeconomic stimulus is needed. In normal times, monetary rather than fiscal policy would be the instrument of choice for macroeconomic stabilisation. But these are not normal times. Current conditions of extreme financial stress have weakened the monetary transmission mechanism. In this unusual situation, fiscal policy stimulus over and above the support provided through automatic stabilisers has an important role to play[14].

The International Monetary Fund noted that fiscal policy can quickly boost spending power, whereas monetary policy acts with long and uncertain lags [15], and a 2009 IMF Staff Position Note demonstrated that an internationally coordinated programme of fiscal expansion, combined with accommodative monetary policies, could have significant multiplier effects on the world economy [16]. However, the IMF also advised that fiscal expansion could do more harm than good in heavily indebted countries such as Japan and Italy stimulus, and suggested that further expansion should be confined to countries with more modest levels of national debt, such as the United Kingdom, China, France, Germany, and the United States [17]. After some early misgivings, the case for fiscal expansion gained near-universal political acceptance, and by early 2009, nearly all the G20 countries had introduced fiscal stimulus programmes [18].

In 2009, as signs of impending recovery began to emerge, the debate about the future of fiscal policy was resumed and, although there was general recognition of the eventual need for an offsetting fiscal contraction, views differed about the timing of such action. In October 2009 the IMF cautioned against haste:

"Notwithstanding already large deficits and rising public debt in many countries, fiscal stimulus needs to be sustained until the recovery is on a firmer footing and may even need to be amplified or extended beyond current plans if downside risks to growth materialize"[3].

The outcome of that debate in most industrialised countries was a decision to postpone further fiscal expansion unless and until the need became apparent, and to develop medium-term plans for fiscal contraction in 2011 and beyond [19].

Objections

Professor Eugene Fama of the University of Chicago argued that consumers do not respond to tax cuts because of awareness that they will eventually be paid for by tax increases (the argument known to economists as Ricardian equivalence. He also argues that all forms of fiscal stimulus are ineffective because they merely move resources from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment [20] (the process known as crowding out). Others have argued that the danger of incurring unsustainable debt [21], makes fiscal stimulus a risky option, especially for countries with high levels of national debt. There is also a danger that even relatively modest levels of debt can become unsustainable if investors perceive a risk of default on its repayment, because they would then add to the problem by adding a risk premium to the interest rates needed to finance the debt. Another objection arises from the fear that expansionary fiscal and monetary policies would not be reversed in time to avoid inflation (that objection was expressed by the economist Allan Meltzer [22] in the same issue of the New York Times in which the economist Paul Krugman was advocating a further stimulus in order to avert the danger of deflation [23]).

Monetary policy

The consensus view

The use of security purchases to increase central bank liabilities as an auxiliary monetary policy after interest rate actions are exhausted (usually referred to as quantitative easing) had been explained by Ben Bernanke in 2004[24] and had been used by the Japanese central bank in the 1990s.

Objections

Although the policy of credit easing that was adopted by the Federal Reserve Bank in 2008 was not new, it received a mixed reception, and press references to it as "printing money" raised fears of inflation. The policy was vigorously attacked by German Chancellor Angela Merkel [25][26], but the President of the Bundesbank defended it, while warning of the need for its timely reversal[27].

Aftermath

As the world economy started to recover, a variety of measures designed to avert a repetition of its underlying financial crisis were proposed, and some were implemented. Accounts of those measures will be available as they develop in the articles on financial regulation, banking and bank failures and rescues.

References

  1. Economic Survey of the United States, OECD December 2008
  2. Ben Bernanke: The Crisis and the Policy Response, Speech at the London School of Economics, January 13, 2009
  3. Ben Bernanke: The Federal Reserve's Balance Sheet: An Update, Federal Reserve Board Conference on Key Developments in Monetary Policy, Washington, D.C. October 8, 2009
  4. Charles Bean: Quantitative Easing: An Interim Report, Speech to the London Society of Chartered Accountants London, 13 October 2009
  5. Claus Vistesen: Quantitative Easing à l´ECB, Global Economy Matters, May 2009
  6. Paul Krugman's fear for lost decade, Interview with Will Hutton, The Observer, Sunday 14 June 2009
  7. Richard Koo: The Age of Balance Sheet Recessions, What post-2008 USA, Europe and China can learn from Japan 1990-2005, Nomura Research Institute, March 2009
  8. U.S. Household Deleveraging and Future Consumption Growth, Federal Reserve Bank of San Francisco Economic Letter 2009-16; May 15, 2009
  9. Quarterly National Accounts briefing note, 2009 Quarter Two, National Statistics Office
  10. A special report on the world economy, The Economist, Oct 1st 2009
  11. Paul Krugman The Obama Gap, New York Times blog 8 January 2009
  12. Joseph Stiglitz "How to Fail to Recover", Project Syndicate, 2009.
  13. Keynesian Over-spending Won't Rescue the Economy", Letter by IEA economists in the Sunday Telegraph, 26 October 2008
  14. Klaus Schmidt-Hebbel: A Long Recession" ,Editorial to OECD Observer No 270, December 2008
  15. Fiscal Policy as a Countercyclical Tool, IMF World Economic Outlook, Chapter 5 , October 2008
  16. Charles Freedman, Michael Kumhof, Douglas Laxton, and Jaewoo Lee: The Case for Global Fiscal Stimulus, IMF Staff Position Note SPN/09/03, International Monetary Fund, March 6 2009
  17. Mark Horton and Anna Ivanova: "The Size of the Fiscal Expansion: An Analysis for the Largest ountries", IMF Fiscal Department Note, February 2009
  18. Eswar Prasad: Assessing the G-20 Stimulus Plans: A Deeper Look, Brookings Institution May 2009
  19. "The State of Public Finances: Outlook and Medium-Term Policies After the 2008 Crisis" IMF March 6 2009
  20. Eugene Fama: Bailouts and Stimulus Plans January 2009
  21. The conditions for fiscal sustainability are set out in paragraph 4.1 of the article on national debt [1]
  22. Allan Meltzer: Inflation Nation, New York Times op-ed, 3rd May 2009
  23. Paul Krugman: Falling Wage Syndrome, New York Times op-ed, 3rd May 2009
  24. Ben Bernanke: Conducting Monetary Policy at Very Low Short-Term Interest Rates, Paper presented to the American Economic Association at San Diego, California, January 3, 2004
  25. Bertrand Benoit Ralph Atkins: Berlin breaks the unwritten rule, Financial Times, June 2 2009
  26. Tony Barber: Merkel derides the Bank of England’s "little line”, Financial Times Brussels Blog, June 5, 2009[2]
  27. Gabi Thesing: Weber Sees Subdued Inflation, ‘Protracted’ Recovery , Bloomberg, September 8 2009