Time constants in the economy

I was struck recently by a figure that economist Paul Krugman posted on his blog of the recovery time from recessions.

The interesting point to me was that there seems to be some consistency in the rate of recovery from different types of recessions. In other words, there are fixed time constants in the economy. A recession is defined as a period with negative GDP growth rate, i.e. it is a time when the economy shrinks.  Generally, the US has been growing a few percentage points a year in real terms for the past several decades. This is interrupted by occasional recessions such as a severe one in 1980-81 and the most recent Great Recession of 2008-2009.

However, not all recessions are created equal and economists have made a distinction between those caused by disinflation and financial crises.  An example scenario for a disflationary recession is that the economy is initially overheated so while there may be lots of growth there is also lots of inflation. The causes of inflation are complicated but they are sometimes linked to the interest rate. When rates are low, it is cheap to borrow, so people can acquire more money to spend and too much money chasing too few goods leads to inflation. A recession can then be induced by interest rates increasing, either through direct action by the Federal Reserve Bank or some exogenous factor, which makes it more expensive to borrow money and also incentivizes saving. This reduces the money supply.  This is what happened in the 1980-81 recession.  Inflation was extremely high in the 1970’s so Fed chairman Paul Volker dramatically increased interest rates. This induced a recession and also curbed inflation.  How the Fed controls interest rates is extremely interesting and something I may post about in the future. A recession can also be caused by no apparent external event if people simply decide to decrease spending all at once. A beautiful example is given by the famous story of a babysitting coop (see here). In a disinflationary recession, the economy can start growing if you can get people to start spending again. This can be done by lowering the interest rate or through a fiscal stimulus plan where the government starts to spend more. The time constant for recovery will be about the time it takes for people who lost jobs to find new ones and this is usually less than two years.

Recessions due to financial crises are generally preceded by a financial bubble where some asset, such as real estate, increases dramatically in price and then people, companies and banks take on more and more debt to try to make money by speculating on this asset. This is what happened in the run up to the Great Recession and the Japanese financial crisis in the 1990’s. When the bubble finally bursts, people are left with lots of debt and little money  to spend, thereby inducing a recession. In the case of real estate, the debt is in the form of mortgages, which are usually long term. The time constant will be the average duration of the mortgage or the time it takes to refinance. In both cases, this will take longer than two years. Thus, the recession will persist until people can pay off or unload their debts and both are difficult when the economy is depressed. It also shows why monetary policy may have little effect. Lowering interest rates can’t directly help the people trapped in long-term mortgages. However, if the interest rates can be kept low enough and long enough to induce some inflation then house prices increase while effective debt decreases so people can sell their homes or refinance and get more money to spend. This is basically what current Fed chairman Ben Bernanke is trying to do.  Another option would be for the federal government to take advantage of low interest rates and start buying property. They could have started a buy-and-lease program where underwater homeowners could sell their homes to the government and then rent it back from them. This would keep people in their homes, bolster the economy and also ensure that people who made bad decisions during the bubble do not profit from their mistakes. When house prices rise again, the government would pocket the profits.