Chapter 4. Dates and Events: What Happened When?
- Ayhan Kose, and Marco Terrones
- Published Date:
- December 2015
Can one claim good knowledge of the U.S. economy without a serious understanding of the U.S. business cycle and its turning points? No! Similarly, a true understanding of the global economy requires a good grasp of the global business cycle and its turning points. In this chapter, we first determine the turning points of the global cycle. These ultimately correspond to the dates of global recessions, recoveries, and expansions. We then provide a brief narrative of the major events that coincided with the turning points of the global cycle. We conclude with a short analysis of the implications of global recessions for macroeconomics.
Turning Points of the Global Business Cycle
We first describe the turning points that we identify using each methodology.
Turning Points Using the Statistical Method
The statistical algorithm identifies four troughs in global economic activity since 1960, and these correspond to declines in world real gross domestic product (GDP) per capita and constitute global recessions: 1975, 1982, 1991, and 2009 (Figures 4.1 and 4.2). The use of market weights rather than purchasing-power-parity weights, which tilts the weighting toward advanced economies, does not affect the set of troughs, with one exception. Using market weights, the trough of the 1991 episode shifts to 1993 because of the recessions in many European countries during the European Exchange Rate Mechanism (ERM) crisis of 1992–93. With both weights, the dates of peaks in the global business cycle are 1974, 1981, 1990, and 2008.
Figure 4.1Evolution of World Output
Note: Shaded bars indicate global recessions.
The implication of these findings is that when measured by market weights, the duration of the 1991 global recession is two years but the duration of other episodes is just one year. With the purchasing-power-parity weights, the duration of all four global recessions is one year. This finding echoes the results from the literature on the features of national recessions. A recent study reports that the average duration of roughly 250 recessions in 44 advanced and emerging market economies since 1960 is also about one year.1
Figure 4.2Growth of World Output
Note: Each panel shows the percent change from a year earlier. World output growth is the weighted average of the growth rate of real gross domestic product of each country (using the purchasing-power-parity or market weights). World output growth per capita is the difference between world real output growth and world population growth. Shaded bars indicate global recessions.
Can we identify a global recession with a simple threshold associated with the growth of world GDP? The answer appears to be no, as Figure 4.2 shows the difficulty of using a growth threshold (such as 3 percent growth in world GDP) to identify a global recession.2 If one assumes that a global recession takes place when world real GDP growth (with purchasing-power-parity weights) is less than 3 percent, the world economy was in recession for 14 years during 1960–2012, and 20 years using market weights over the same period.3 If one uses growth rates per capita (with purchasing-power-parity weights) and assumes that the threshold is 1 percent, there were nine years of global recession since 1960.4 With the use of market weights, there were 13 years of global recession. The growth of world GDP needs to fall below roughly 1.3 percent to register a contraction given the average rate of population growth in the 2000s.5 But it is important to recognize that this statistic is time variant, with substantial changes from one decade to another.6
Turning Points Using the Judgmental Method
The judgmental method is applied at the global level by looking at several indicators of global activity: real GDP per capita, industrial production, trade, capital flows, oil consumption, and unemployment. Figure 4.3 shows the evolution of these indicators. The behavior of most indicators points to an obvious contraction in global economic activity after it peaked in the preceding year.7 These periods also coincide with declining growth in global consumption and investment and sharp downturns in global credit and asset and commodity prices (Figures 4.4, 4.5, and 4.6). We discuss the behavior of these variables during the global recessions and recoveries in more detail in the next two chapters.
Figure 4.3Evolution of Global Activity Variables
Note: World output growth is the difference between the purchasing-power-parity-weighted output growth rate and the population growth rate. World industrial production growth is the purchasing-power-parity-weighted industrial production growth of all countries. World trade growth is the growth rate of exports and imports of all countries. World capital flows correspond to the change in the ratio of total capital flows to gross domestic product, where total capital flows is the absolute sum of total inflows and total outflows. World unemployment rate is the labor-force-weighted unemployment rate of all countries. World oil consumption is the change in oil consumption. Shaded bars indicate global recessions.
Figure 4.4Evolution of World Consumption and Investment
Note: Each panel shows the percent change from a year earlier. World consumption (investment) growth is the weighted average of the growth rate of consumption (investment) of each country (using the purchasing-power-parity or market weights for output). Per capita world consumption (investment) growth is the difference between world consumption (investment) growth and world population growth. Shaded bars indicate global recessions.
Figure 4.5Evolution of World Credit, House Prices, and Equity Prices
Note: Each panel shows the four-quarter average of market-weighted growth rates of respective variables for advanced and emerging market economies. All variables are in real terms. House price data start in 1970. Growth in world credit and world equity prices start in 1962; the market weights are three-year rolling averages. Shaded bars indicate global recessions.
Figure 4.6Evolution of World Commodity Prices
Note: Each panel presents the year-over-year growth rate of the respective real commodity price. The real growth rate of commodity price corresponds to the nominal growth rate deflated by world inflation, which is the year-over-year growth rate of the world consumer price index. Shaded bars indicate global recessions.
Is It Just a U.S. Recession? No!
It is natural to ask whether the global recessions we identified were always accompanied by recessions in the United States. Although the four global recessions indeed coincided with recessions in the United States, not every U.S. recession was associated with a global recession. Specifically, the United States experienced eight recessions during 1960–2014 whereas the global economy experienced only four.8 In other words, a recession in the United States does not necessarily imply a global recession.
Events Surrounding the Global Recessions
The four turning points we identify coincided with severe economic and financial disruptions in many countries around the world—these were periods of collapse for the world economy. Before we document the main properties of the global recessions and recoveries in the next two chapters, we briefly describe the major events that took place around these critical turning points.9 Our objective is not to pinpoint the causes of the global recessions but simply to remind readers of the gravity and complexity of the events that coincided with these episodes.
The world economy faced unique challenges during each episode. The underlying shocks that led to the collapse of the world economy worked differently in each of the four episodes. A truly global shock—a sharp increase in oil prices—drove the 1975 recession. A series of global and national shocks, including the oil price shock in 1979, and subsequent policies and events—especially the Volcker disinflation and the Latin American debt crisis—played significant roles in the 1982 episode.
However, there were also multiple similarities in how the global economy descended into these full-blown recessions. A number of countries experienced financial crises during the global recessions.10 While the 1991 event coincided with a wide range of global and national shocks, it became a worldwide event through transmission of various national shocks across borders: financial disruptions in the United States, Japan, and several Scandinavian countries; exchange rate crises in many advanced European economies; German unification; and the collapse of the Soviet Union in eastern Europe. The 2009 global recession started with problems in the U.S. financial sector in 2007, but it rapidly spread to other advanced economies and some emerging market economies through trade and financial linkages.
We now turn to a brief narrative of each global recession. In the notes at the end of the book, we provide a rich set of excerpts taken from media reports around the years of global recessions. These show that each global recession brought memories of the Great Depression of the 1930s and often led to pessimistic predictions about the future of the world economy. Appendix E also includes a detailed timeline of events around global recessions.
The global recession of 1975 followed the first major oil price shock the world economy had ever experienced.11 Oil prices shot up fourfold following the Arab oil embargo that began in October 1973, when Egypt, Syria, Tunisia, and Arab members of the Organization of the Petroleum Exporting Countries (OPEC) initiated the embargo to protest U.S. support to Israel in the Arab-Israeli conflict. Although the embargo ended in March 1974, the supply shock associated with the sharp rise in oil prices quickly translated into a substantial increase in inflation and a sharp decline in output in a number of countries. Specifically, the global recession of 1975 marked the beginning of a prolonged period of stagflation, with low output growth and high inflation in the United States. In addition, the Group of Seven countries except Germany—Canada, France, Italy, Japan, the United Kingdom, and the United States—experienced relatively high inflation.12 As we describe later, sharp movements in oil prices also appear to have played important roles in the recessions of 1982 and 1991.13
The global recession of 1975 followed the first major oil price shock the world economy had ever experienced and ushered in a period of stagflation.
Oil-importing countries have since taken numerous steps to reduce their vulnerability to such shocks. They increased the number of sources from which they import oil, making them less vulnerable to disruptions from any one source, and substituted other sources such as natural gas and renewables, including solar and wind. In advanced and emerging market economies, there have also been increases in energy efficiency, with a steady decline in the amount of energy needed to generate a dollar of income.
Moreover, central banks have become much better at anchoring inflation expectations by communicating that oil price increases do not alter longer-run inflation prospects. The public in many countries is therefore much less fearful of the inflationary consequences of higher oil prices. Increases in oil prices are no longer expected to feed a wage-price spiral, as they did in the 1970s. Nevertheless, while countries have built up some ability to withstand oil shocks, they remain vulnerable to severe supply disruptions or to the uncertainty induced by extreme oil price volatility.
The global recession in 1982 was associated with a variety of events, including a rapid increase in oil prices, tight monetary policies in several advanced economies, and the Latin American debt crisis.14 A second major oil price shock hit the global economy in 1979 during the Iranian revolution as prices jumped almost threefold. Inflation then reached new highs in several advanced economies (reaching 13.5 percent in the United States and 17 percent in the United Kingdom in 1980).
After the 1975 global recession, many advanced economies implemented accommodative policies for a prolonged period to revive economic growth. However, several started to pursue contractionary monetary policies to reduce inflation in the early 1980s.15 These coincided with a sharp decline in activity along with a significant increase in the rate of unemployment in the United States and several other advanced economies during 1982–83.
A number of Latin American countries accumulated large debts during the 1970s (mainly funded by the petrodollar windfall of the oil-exporting countries). However, the sharp increase in global interest rates and the collapse of commodity prices in the early 1980s made servicing this debt very difficult.16 Mexico’s default in August 1982 marked the beginning of the Latin American debt crisis and the region’s decade-long stagnation (known as the “lost decade”). Debt crises afflicted a number of countries in the region, including Argentina, Mexico, and Venezuela in 1982 and Brazil and Chile in 1983.17
The global recession in 1982 was associated with a variety of events, including a rapid increase in oil prices, tight monetary policies in several advanced economies, and the Latin American debt crisis.
The 1991 global recession also reflected a host of problems in many corners of the world: difficulties in U.S. credit markets, banking and currency crises in Europe and the challenges of east Europe’s economies transitioning away from communism, the bursting of Japan’s asset price bubble, and uncertainty stemming from the first Gulf War and the subsequent increase in the price of oil.18 The U.S. savings and loan crisis persisted from the mid-1980s to the mid-1990s, and close to 25 percent of financial institutions providing savings and loan services failed.19 These developments coincided with a prolonged period of depressed activity in the U.S. housing market and a credit crunch that began in 1990. Unemployment started to increase in 1989, and the economy went into recession in July 1990.20
The early 1990s were an extremely challenging period for many countries in Europe. First, there were severe banking crises in several Scandinavian countries in early 1991. Finland, Norway, and Sweden had liberalized their financial sectors in the 1980s and enjoyed rapid growth accompanied by a significant expansion of credit before going through deep recessions largely because of these crises.
Second, the ERM among 11 European currencies disintegrated in 1992, and the ensuing crisis coincided with a sharp decline in activity in many of the member countries.21 The ERM was simply a managed float in which currencies were allowed to fluctuate within predetermined bands. Although the system had worked well for a long time, several members of the ERM ran into competitiveness problems and their currencies faced speculative attacks after Germany increased interest rates in 1992 to control inflation (following unification in 1990). Ireland, Italy, Portugal, Spain, and the United Kingdom were all forced to devalue their currencies in 1992–93 and then experienced deep recessions.
The 1991 global recession reflected a host of problems, including difficulties in U.S. credit markets, banking and currency crises in Europe and the challenges of eastern Europe’s transition, the bursting of Japan’s asset price bubble, and the uncertainty stemming from the first Gulf War and the subsequent increase in the price of oil.
Third, the transition to market economies by the former communist bloc countries in eastern Europe also caused difficulties in the early 1990s. In particular, output in these economies fell significantly at the start of the transition, by 40 percent on average before it bottomed out.22
Finally, after enjoying robust growth and soaring asset prices during the 1980s, Japan experienced a recession in the early 1990s that was accompanied by a collapse in equity and house prices. The recession began a prolonged period of stagnation—Japan’s own lost decade. In addition, the first Gulf War (August 2, 1990–February 28, 1991) pitted a U.S.-led international coalition against Iraq following Iraq’s invasion of Kuwait, and the associated increase in oil prices hurt global activity.23
The 2009 global recession followed the worst financial crisis since the stock market crash of October 1929 and the subsequent Great Depression of the 1930s. Although financial crises have always been a recurrent feature of global recessions, the latest episode included an unusually large number of severe crises in advanced economies. The crisis started in mid-2007 in the major advanced economies after an extended period of macroeconomic stability accompanied by financial exuberance. The buildup to the crisis featured asset price and credit booms in a number of countries; a dramatic expansion in the volume and variety of marginal loans, particularly in mortgage markets; and a period of relatively lax regulation and supervision of financial markets and institutions.24
Although the U.S. mortgage markets were at the epicenter, the financial crisis quickly spread to other financial market segments in many other countries and turned into a global crisis after the collapse in September 2008 of the investment bank Lehman Brothers, which had a very large international exposure.25 A number of financial institutions failed in the United States and Europe (we list some of them in Appendix E). The pervasive interconnectedness of national and international financial markets, with the United States at the core, helped transmit the crisis to other advanced, emerging market, and developing economies.26
The 2009 global recession followed the worst financial crisis since the stock market crash of October 1929 and the subsequent Great Depression of the 1930s. This latest episode included an unusually large number of severe crises in advanced economies.
The crisis led to prolonged asset price busts and credit crunches, a collapse in global trade, and highly synchronized recessions in many countries around the world in 2009. Banking crises erupted in many European countries in 2008 and turned into a regionwide sovereign debt crisis in 2011–12. A Focus box at the end of the chapter provides additional information on the similarities and differences between the 2007–09 global financial crisis and earlier ones.27 While they were somewhat peripheral to the bigger story of the financial crisis, oil prices also increased sharply (spiking to $133 a barrel in July 2008 from $53 in January 2007) in the run-up to the global recession.
True Turning Points for Macroeconomics
Global recessions have not been turning points only for the world economy, but by sparking a rethinking of macroeconomic theories and policies, they have also been transformative events for the economics profession. For example, prior to the 1975 recession, the dominant macroeconomic framework was the Keynesian approach to policymaking, which emphasized the importance of movements in aggregate demand as the main source of economic fluctuations. This view naturally lent support to the use of macroeconomic policies to stimulate aggregate demand to fine-tune business cycle fluctuations. Under the standard Keynesian framework, the coexistence of inflation and stagnation in activity was considered impossible.
Global recessions have not been turning points only for the world economy, but by sparking a rethinking of macroeconomic theories and policies, they have also been transformative events for the economics profession.
During the 1975 global recession and the ensuing recovery, many advanced economies did in fact experience both high inflation and stagnation, a phenomenon known as stagflation. As a consequence, macroeconomics went through a period of soul-searching, and new theories were developed that gave more prominence to the shocks originating on the supply (production) side of the economy.28 Other theories showed how policies that affect nominal variables (and target aggregate demand) can have only temporary effects on macroeconomic outcomes in environments with rational agents and flexible prices.29
The 1982 and 1991 episodes were also important turning points for macroeconomics. The global recession of 1982, for example, led to a serious assessment of monetary policy, especially in advanced economies.30 There was substantial progress in the design and objectives of monetary policies as inflation increasingly became the key concern of central bankers. The global economy enjoyed a period of “Great Moderation” from the mid-1980s until the global financial crisis. Some argued that improvements in monetary policy played an important role in delivering stable output and inflation outcomes during this period.31
As discussed, the 1991 episode was an amalgam of adverse events, including problems in credit and housing markets in the United States, banking crises in several Scandinavian countries, currency crises in many European countries, the bursting of the Japanese asset price bubble, and the structural and cyclical problems of eastern European transition economies. These events intensified research on the linkages between credit markets and the real economy, determinants of exchange rate movements, and the sustainability of currency unions. New research led to revolutionary changes in the institutional structures of central banks and the design of monetary policies. During the 1990s, a number of countries undertook reforms to increase the independence of their central banks. Many central banks adopted inflation targeting as the foundation of their monetary policies. A new line of research focused on a wide range of problems associated with the transition of eastern European countries to market economies.
The latest recession was a truly dramatic turning point because it showed the limitations of macroeconomic models to analyze the implications of financial intermediaries and instruments for activity. Moreover, debates on economic policies in the wake of the crisis have clearly illustrated the constraints of available policy measures to cope with the devastating effects of the global recession.32 In subsequent chapters, we provide a detailed discussion of these policy issues.
Focusing Next on the Effects
This chapter describes the main events that took place around global recessions and shows the complex circumstances that led to the collapses of the world economy. We now turn to the sad stories of these collapses by presenting an empirical analysis of their main features in the next chapter.
The Global Financial Crisis
The proximate cause of the 2009 global recession was the financial crisis that started in the United States in 2007 and quickly spread around the world through financial and trade linkages. The crisis had multiple and interlinked causes, some common to past crises and others more unique.33
There are at least four elements common to financial crises. The first is rapid appreciation of asset prices. The pattern of “exuberant” asset prices in the United States and other advanced economies prior to the 2007–09 crisis is reminiscent of other crises, including the so-called Big Five banking crises (Finland, 1991; Japan, 1992; Norway, 1987; Sweden, 1991; and Spain, 1977).
The second common element is credit booms or, more generally, rapid financial expansion. Much research has documented how episodes of unusually sharp credit expansions end in crisis (Mendoza and Terrones 2012). As in past episodes, international financial integration helped facilitate credit expansion in various corners of the world in the run-up to the Great Recession.
The third is the emergence of systemic risks. In the United States and other advanced economies, systemic risk arose from the housing sectors. In other countries, particularly in emerging Europe, it arose from the large amounts of credit extended in foreign currency.
The final common element is a failure of regulation and supervision to restrict excessive market behavior. As in many previous episodes, the large credit expansions before 2007 were associated with poorly supervised and unregulated financial innovation, and as in many previous episodes, the result was a crisis.
The latest episode is unique in many respects. First, problems in the household sector played a more prominent role than in previous financial crises. Most previous episodes stemmed from problems in the public sector (such as the Latin American debt crisis of the 1980s) or the corporate sector (such as the Asian financial crisis of the late 1990s). In many countries, however, the latest crisis largely originated from “overextended” households. This had major implications for how the crisis was transmitted from the financial to the real sector and complicated the design of resolution mechanisms and policy responses.
Second, leverage increased sharply in the financial sector, directly so among commercial banks in Europe and through the shadow banking system (investment banks and non-deposit-taking institutions) in the United States. High leverage limited the ability of financial systems to absorb even small losses and contributed to the rapid decline in confidence and increase in counterparty risk early in the crisis.
Third, there has been a dramatic increase in the extent of international financial integration over the past three decades, and global finance now involves many players from various markets and different countries. Many financial instruments that originate in the United States are held in other advanced economies and by the official sector in several emerging market economies. While increased financial integration has conferred many benefits, these extensive links meant the crisis in U.S. financial markets quickly turned into a full-fledged global crisis and made a coordinated solution much more difficult.
Finally, financial instruments have become more complex and opaque over time. Securitization, spurred by the use of innovative (and highly complex) financial instruments, has been critical in the rapid expansion of credit, particularly mortgage credit, in the United States. However, the increased recourse to securitization and the expansion of the originate-and-distribute model has exacerbated agency problems—that is, the problems with motivating one party (the agent, in this case the financial institution) to act in the interests of another (the principal, in this case the investor). The distribution model led to widespread reliance on ratings for the pricing of credit risk. Moreover, investors were often unable or unwilling to fully assess underlying values and risks. This lack of understanding quickly led to a confidence crisis during 2007–09.