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Thursday, October 11, 2012

Simple Proof That Strong Growth Has Typically Followed Financial Crises

People are looking for answers to why the economy is growing so slowly. Is the answer that economic growth is normally weak following deep recessions and financial crises, as, for example, Kenneth Arrow argued in the presidential election event with me this week at Stanford? Or is poor economic policy the answer, as I argued?

In my view the facts contradict the “deep recession cum financial crisis” answer, so I have focused my research on economic policy and have found that the answer lies there. The chart below illustrates these facts. It is derived from historical data reported in a paper by economic historians Michael Bordo of Rutgers and Joe Haubrich at the Cleveland Fed.

The bars show the growth rate in the first four quarters following all previous American recessions that are associated with financial crises, as identified by Bordo and Haubrich. The upper line shows the average growth rate in all those recoveries. The lower line shows the growth rate in the four quarters following the 2007-2009 recession. It is very clear that recessions with financial crises are normally followed by much more rapid recoveries than this current recovery. The current recovery not only started out weak, averaging 2.5% in the first year, it got weaker over time, declining to only 1.3% in the second quarter of this year.

Growth was nearly 4 times stronger on average in the past recoveries. The only recovery in this list in which growth was as weak as this one followed the 1990-91 recession, but that was from a very shallow recession with output declining only 1.1%, so growth did not need to get very high to catch up. (The chart would look very similar if instead of 4 quarters you use the length of the recession from peak to trough as Bordo and Haubrich also do).

With such obvious evidence, how can people come to different views? Usually they mix in experiences in other countries with different economies at different points in time, as for example Carmen Reinhart and Kenneth Rogoff have done in an often cited book. But this approach can lead to mistaken conclusions, as Bordo explained recently in the Wall Street Journal. As he put it, “The mistaken view comes largely from the 2009 book "This Time Is Different," by economists Carmen Reinhart and Kenneth Rogoff, and other studies based on the experience of several countries in recent decades. The problem with these studies is that they lump together countries with diverse institutions, financial structures and economic policies.”