A 2010 equity portfolio: two types of recession, two types of recovery

Two types of recession

Looking at recessions in a very simple way–but good enough for our purposes–economist divide them into two types.

1.  The garden variety starts when the economy is growing at a faster rate than the central bank thinks it should.

This means different things in different countries.  In the EU, for example, excessive growth means a rate of expansion that contains the slightest risk of inflation.  In the US, in contrast, the Fed’s job is to encourage maximum sustainable GDP growth, with acceptably low inflation–meaning in today’s world a maximum of 2%.  Let’s consider the US case.

When the economy has expanded to the point where there is very little unused labor, firms that want to expand begin to offer large wage increases to lure workers from other companies.  This wage competition–by raising the overall level of salaries–creates the threat of excessive inflation.

The Fed reacts by raising interest rates to slow the expansion down.  After six months to a year, seeing it has created some slack in the labor market and that the economy is dipping below its growth potential, the Fed begins to reverse course and lower rates again.

2.  The less frequent, but deeper and longer, recessions may have all of the elements of the garden variety business cycle type, including the central bank’s raising rates to attempt to fight inflation.  But the real defining characteristic of the deeper recessions is what economists have called an exogenous event, or an external shock. In the case of the deep recessions of 1973-74 and 1980-82, the external shock involved was the negative effect of an almost-overnight tripling in worldwide oil prices on industrial economies deeply dependent on petroleum.

Two types of recovery

Recovery from the garden variety recession is straightforward.  The central bank, which created the slowdown by adjusting short-term interest rates upward, moves them back down again and the economy gradually picks up speed.

Recovery from deeper recessions is also straightforward–elimination of the causes of the economic slowdown.  But it’s harder to accomplish, and takes longer to achieve, because it involves structural adjustment to a new set of economic realities.

The 2007-2009 recession

The very deep recession which has just ended doesn’t appear at first to fit neatly into the “external shock” category.  There are two reasons for this:  the commodity whose supply/demand characteristics has changed is money; and the source of the systematic shock is not a far-off and exotic land, but the center of the western financial world, the US and the UK.

Nevertheless, as was the case in other deep recessions, recovery in this instance, too, will consist both in adjustment to the new economic realities and in repair of the damage done by having assumed that the old “business as usual” would go on forever.

That’s it for now.  In my next post, I’ll try to spell out the specific recovery issues we now face.

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