Chapter 12. Lessons: Past, Present, and Future
- Ayhan Kose, and Marco Terrones
- Published Date:
- December 2015
I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not.
Narayana Kocherlakota (2010)
The global economy is at a critical juncture. Most economists agree on what is needed to avoid another round of lost growth opportunities, inadequate employment, financial instability, and worsening inequality. Central banks and markets cannot achieve an orderly global rebalancing on their own. As difficult as it may be, politicians need to pursue comprehensive policy responses. The longer they delay, the less effective their efforts will be.
Mohamed El-Erian (2015)
“We live in a global world” is a cliché of our time, but there is no commonly accepted definition of a global recession to tell us when our economic world has gone off track. We have provided definitions of the concepts of global recession and recovery, presented a comprehensive analysis of the main features of these episodes, studied the unique properties of the 2009 global recession and the subsequent recovery, and examined the complex interactions between global and national growth. What can we draw from our analysis? What are the implications for the design of policies? And for future research?
What Was Our Objective?
This book addresses a critical need: despite the repeated use of “global recession” and “global recovery” since 2006, there are no commonly accepted definitions of these terms. One reason may be that, especially before 2007, the world economy had enjoyed an extended period of stability stretching back to the mid-1980s, the so-called era of Great Moderation. Moreover, the spectacular performance of the world economy during 2002–07 made the concept of a global recession an odd thing to worry about.
The spectacular performance of the world economy during 2002–07 made the concept of a global recession an odd thing to worry about.
Understanding these two terms became increasingly important after the severe 2009 global recession and the fragile ensuing recovery. There has been a lot of confusion over these terms, rooted in the difficulty of decomposing the global business cycle into the well-known phases of national business cycles. While national cycles naturally go through periods of contraction and expansion, the global cycle rarely contracts outright.
This book presents the first comprehensive analysis of global recessions and recoveries. It defines these concepts and documents their main features. We analyzed the specific properties of the latest global recession and recovery in light of the lessons of three previous episodes since 1960 (1975, 1982, 1991). We also examined the interactions between global and national cycles.
What Did We Learn?
Getting the concepts right. Our definitions of global recessions and recoveries follow the standard definitions of national cycles. Specifically, we define a global recession as a contraction in world real GDP per capita accompanied by a broad decline in various other measures of global economic activity. A global recovery corresponds to a rebound in worldwide activity in one to three years following a global recession. These definitions lead to natural parallels between the phases of the global business cycle and those of national cycles.
Four global recessions. Since 1960, the world economy experienced four global recessions: 1975, 1982, 1991, and 2009. These four dates constitute clear reference points for comparisons. Although each episode presented unique difficulties for the world economy, they also shared multiple similarities.
Events surrounding the global recessions. After identifying the dates of global recessions, we presented brief descriptions of the relevant events surrounding each episode. Global recessions often occurred under complex circumstances, but each episode was characterized by specific events. For example, the 1975 global recession coincided with a sharp increase in oil prices and left an enduring recognition of the importance of supply shocks. The 1982 global recession also featured gyrations in oil markets but came on the heels of the employment of contractionary monetary policies in the major advanced economies and financial crises in some emerging market economies. The global recessions of 1991 and 2009 took place alongside financial crises in many advanced economies.
Main features of global recessions and recoveries. Global recessions feature synchronized declines in world output per capita, employment, industrial production, trade and capital flows, and oil consumption. The average decline in world output per capita during the four global recessions is about 0.7 percent, roughly 3 percentage points lower than its historical average.
In addition to the four global recession episodes, the world economy experienced two global downturns, in 1998 and 2001. Discussions during each of these downturns centered on the likelihood that a global recession would ensue, reflecting the confusion about the definition of a global recession. In both years, world growth was indeed quite low, some indicators signaled vulnerability, and many countries had indeed entered a recession. That said, world output per capita did not decline, and worldwide activity showed no broad-based weakness.
Global recoveries are often accompanied by a rebound in activity, which is generally driven by a synchronized revival in worldwide consumption, investment, and trade. Most indicators of global activity also recover and start registering growth in the first year of recovery. Specifically, industrial production, trade, and capital flows quickly bounce back during the first year of a global recovery. Credit and asset prices fluctuate sharply during global recessions and recoveries. These results together indicate that there are strong parallels between the main features of the global business cycle and those of national cycles.
The 2009 global recession. The 2009 episode was the most severe and most synchronized global recession of the past half century. In fact, it was the only episode during which world output contracted outright. A collapse in international trade and capital flows accompanied the recession, and global unemployment rose rapidly.
The global recovery since then has been comparable to previous episodes. However, it has followed surprisingly divergent paths in the advanced and emerging market economies: it has been the weakest recovery yet for advanced economies and the strongest for emerging market economies. The latest recovery is similar to the one that followed the 1991 recession in multiple dimensions. In both cases, the ripple effects of a collapse in credit and asset markets in the advanced economies hurt the global economy. Moreover, lingering effects of financial crises and policy challenges in Europe slowed both recoveries.
What Are the Key Lessons?
Why was the 2009 global recession so deep? Why has the recovery been so sluggish? The severity of the 2009 global recession and the unusually sluggish nature of the ensuing recovery have been the subject of intense debates. We analyzed various explanations: the highly synchronized nature of the global recession; the severity of the financial crisis during 2007–09; unusually high levels of macroeconomic and policy uncertainty during the recovery; and the surprising divergence of macroeconomic policies and their effectiveness after 2010.
The 2009 global recession was the most severe and most synchronized global recession of the past half century. Almost all the advanced economies and roughly half the emerging market and developing economies were in recession in 2009.
An unprecedented degree of synchronization. One of the distinguishing features of the 2009 global recession was the unprecedented degree of synchronization of national recessions. The number of countries in recession was at a historical low during 2006–07. But in a dramatic reversal, almost all the advanced economies and roughly half the emerging market and developing economies were in recession in 2009. The gravity of the global financial crisis and the forces of trade and financial globalization are significant factors in explaining the extraordinary extent of the latest global recession.
Highly synchronized recessions are longer and deeper than other recessions. In parallel, recoveries from synchronous recessions are very slow and tend to be weaker than other recoveries. When highly synchronized recessions occur, a domestic recovery driven by a turnaround in net exports becomes difficult. Indeed, compared with other recessions, exports are typically more sluggish in highly synchronized recessions, and financial markets struggle. The significant narrowing of global imbalances—which had reached their peak the year before the global financial crisis—is the result of the expenditure reduction in deficit economies, which in turn led to a compression in imports.
A financial crisis for the ages. The severity of the 2007–09 financial crisis and the fact that the original crisis was followed by a massive sovereign debt and banking crisis in the euro area also explain why the 2009 global recession was so deep and the ensuing recovery so sluggish. Financial crises can prolong and deepen recessions through a variety of channels as the adverse feedback loops between the real economy and the financial sector are magnified. Firms and households face a significant erosion of wealth and capital as sharp declines in asset prices reduce net worth; this in turn constrains consumption and investment.
Financial crises are also followed by weak recoveries. Specifically, it takes longer to recover from recessions accompanied by financial crises, and such recoveries are generally more sluggish. Consumption typically grows more slowly than during other recoveries, and investment continues to decline even after the end of the recession. Output growth stays weak, and the unemployment rate tends to climb more than usual during recoveries following recessions with financial crises. Moreover, credit and asset markets often experience prolonged busts during recoveries following recessions that coincide with financial crises.
High uncertainty. High uncertainty has been another factor prominently blamed for stifling the recovery—including uncertainty about macroeconomic prospects and economic policies and regulations. Uncertainty can undermine economic growth through multiple channels. When faced with high uncertainty, firms reduce investment demand and delay projects, and consumers reduce consumption of durable goods. In addition, the adverse effects of uncertainty become more pronounced during periods of financial stress.
The evidence we present indicates that uncertainty tends to be detrimental to economic growth. High uncertainty is often associated with a large drop in investment and consumption growth. Recessions accompanied by high uncertainty are often deeper than others and the recoveries weaker. Policy-induced uncertainty is also negatively associated with growth.
Great divergence of policies. Since 2007, a fierce debate has raged about the roles played by fiscal and monetary policies in dampening the impact of the global financial crisis. Some claimed that the depth of the 2009 global recession required a massive policy response, but others disagreed. As these debates became more passionate, the 2009 global recession gradually differentiated itself from previous global recessions: the direction of fiscal and monetary policies, which had been aligned during previous episodes, diverged, mainly in advanced economies.
The direction of fiscal and monetary policies, which had been aligned during previous global recessions, diverged after the 2009 global recession.
Since 2008, monetary policy has clearly served its function by restoring financial sector health and mitigating the adverse effects of the global recession in advanced economies. The major central banks aggressively employed the policy weapons in their arsenals, especially during the initial stages of the financial crisis. They slashed interest rates to almost zero, expanded liquidity facilities, and started purchasing longer-term assets. The combination of near zero interest rates and record expansions of central bank balance sheets was unprecedented.
Although monetary policy in advanced economies remained exceptionally accommodative, fiscal policy followed a different trajectory. During 2008–09, many advanced and emerging market economies responded to the global recession with wide-ranging, expansionary fiscal measures. These policies were helpful in supporting the real economy during the height of the financial crisis. However, many advanced economies started withdrawing fiscal support in 2010 and employed increasingly contractionary fiscal measures to address record-high public debt levels, and market pressures and political constraints forced policymakers to embark on front-loaded fiscal adjustment programs. The change in policies created substantially different paths for government expenditures in advanced economies than during past recoveries, when policy was decisively expansionary.
In addition, the effectiveness of these policies also appears to have diverged in a detrimental fashion. Monetary policy has been supportive of the recovery but has become less potent because of the zero lower bound on interest rates and the massive disruption in channels of financial intermediation. Contractionary fiscal policy has become a more powerful drag on growth because of the same zero lower bound and the extent of slack in advanced economies. The divergence of policies and their effectiveness thus appears to be one factor that has made the ongoing recovery unusually weak.
Which factor is most important? It is natural to ask which of these four factors has played a more important role in driving growth outcomes during the latest recession and ongoing recovery. We think each factor has played a distinctive role. It is very difficult, if not impossible, to perfectly disentangle the impact of one from the others since there have been close interactions among them. For example, policy uncertainty has been naturally related to policies in place. In addition, the extent of financial disruption has inevitably shaped the design of policies. Our broader message is that the regrettable coincidence of these four factors has led to an extraordinarily severe recession and a painfully weak recovery.
Interactions between global growth and national growth. The global cycle behaves significantly differently during recessions and recoveries. In addition, there are substantial differences in national growth outcomes across country groups depending on the phase of the global cycle. These suggest that it is difficult to have a good grasp of global recessions and recoveries without understanding the linkages between the global and national business cycles. While national business cycles are tightly linked to the global business cycle, the strength of this linkage varies significantly over the cycle. In particular, national cycles are more sensitive to developments in the global economy during global recessions than during expansions. There are also significant differences in how various groups of countries respond to the global cycle. Advanced economies appear to be more sensitive to global recessions than emerging market and developing economies. Moreover, countries tend to be more susceptible to the global cycle the more integrated they are with the world economy.
Four Policy Messages
A study of global recessions and recoveries during the past half century can suggest a wide range of policy implications. We focus on four general policy lessons: the importance of having sufficiently large policy space to respond, the significance of policies targeting macro-financial stability, the value of a sustainable growth strategy, and the role of international coordination of policies.
Policy space: the larger the better during global recessions. Having sufficient policy space to counteract adverse shocks is always critical, but it is even more important during a global recession. National growth outcomes become more sensitive to global growth during global recessions. Moreover, a global recession means that an economy can no longer rely on external demand to support domestic activity.
The 2009 global recession clearly demonstrates the importance of policy space. In terms of fiscal policy, because of high levels of debt, many advanced economies rapidly exhausted the policy space they had prior to the global recession and were forced to shift from expansionary to contractionary policies early in the recovery. In the context of monetary policy, a number of advanced economies quickly lost their ability to use interest rates as a policy instrument because of the zero lower bound. In contrast, emerging market economies had more policy room to counteract the global recession, and partly because of the policies they employed, they were quite resilient during the crisis.
Policies for macro-financial stability: be aware of risks. A lesson from the devastation caused by the 2007–09 global financial crisis is that close monitoring of cycles in financial markets should be an integral part of macroeconomic surveillance and policy design. During the 2009 global recession, powerful adverse feedback loops between the real economy and the financial sector pushed many countries into deep recession and resulted in weak recoveries. The multidimensional interactions between financial and business cycles are especially forceful in a highly integrated global economy with sophisticated financial markets. In addition to the traditional linkages between the inflation and business cycles, monetary policymakers should take into account the state of cycles in financial markets when formulating monetary policies.
Close monitoring of cycles in financial markets should be an integral part of macroeconomic surveillance and policy design.
It is also important to account for the interactions among financial cycles when designing regulatory policies to ensure the health of the overall financial system. Again, the 2009 global recession provides a clear policy lesson: because cycles in housing markets and credit tend to enhance each other, if both house prices and credit are rapidly growing, it might be necessary to employ stricter rules and standards for mortgage lending as well as larger countercyclical buffers to moderate fluctuations in banks’ capital positions. Moreover, it is imperative to consider the global aspects of financial regulation and surveillance policies since domestic financial cycles are often highly synchronized internationally.
A balanced growth strategy. Global recessions offer painful reminders of the importance of a balanced growth strategy supported by both domestic and external demand. Excessive reliance on external demand creates a host of vulnerabilities to demand shocks originating in trade partners, especially during global recessions. For those countries that rely heavily on exports to generate growth, it is important to balance the risks of greater trade openness by creating a more diversified export base along with a broader set of trading partners. In addition, policy measures to stimulate domestic demand are important.1 These measures can translate into a more diversified exposure to world export markets.
Policy coordination: essential during global recessions. In the event of an isolated domestic recession stemming from a country-specific shock, a country can respond with various policy measures if it has a sufficient policy buffer. In the event of a global recession, countries often have to cope with a global shock and must respond by coordinating their policies. In a highly integrated world economy, the reach of a global recession is likely to be wider, making policy coordination even more essential to mitigate the adverse effects of global shocks.2
The latest global recession spurred an unprecedented degree of policy coordination, especially at the height of the crisis in 2008–09.3 Specifically, the crisis made the Group of Twenty (G20) a significant forum for dialogue on issues related to global economic and financial stability.4 The G20 was formally established in September 1999, but the first meeting of the G20 leaders took place at the height of the crisis in November 2008 to formulate policies to respond to the crisis. The G20 was able to successfully coordinate expansionary fiscal and monetary policies in late 2008 and early 2009, which were instrumental in helping the global economy emerge from the global recession.5 As advanced economies navigate the uncharted waters of policy normalization, it is again critical that they coordinate policies to achieve better growth outcomes while reducing financial market volatility.6
Future Work: What Is Next?
Our findings indicate the need to further improve our understanding of global recessions and recoveries. There are a number of potential avenues for future research.
Human and social costs. It is vital to develop a better understanding of the human and social costs of global recessions, which are periods of collapse in the growth of income per capita, but more important, are periods of enormous pain with large human and social costs. The costs include the loss of jobs and income, an increase in poverty and inequality, and the loss of human capital. It is clear that the study of such costs and the design of policies that help reduce them should be a critical component of future research.
Designing policies that help reduce the enormous human and social costs of global recessions should be a critical component of future research.
Macroeconomic models and policies. Global recessions have occasioned a rethinking of macroeconomic theories and policies. The 1975 recession showed the importance of supply shocks, leading to a new generation of models emphasizing the critical role of microeconomic foundations. The 1982 and 1991 episodes led to substantial changes in the design of monetary policy and paved the way for new research on a wide range of critical issues, including linkages between credit markets and the real economy, determinants of exchange rates, and currency unions. The 2009 global recession was a truly tectonic episode for macroeconomics because it starkly exposed the limits of macroeconomic models and policies.
The implications of these observations are clear: research on policies is more urgent than ever. Years after the 2009 global financial crisis, its deep scars remain visible all around. Many advanced economies are still struggling with low growth, large public and private debt, persistently high unemployment rates, and impaired financial systems. Emerging market economies are experiencing what appears to be a synchronized slowdown amid financial market problems. There is consensus that the economics profession needs to develop a richer menu of fiscal, monetary, financial sector, and structural policies.7
National and global business cycles. Another natural topic for future research is how various countries are affected by the global business cycle. Specifically, it would be useful to undertake a deeper analysis of the differential effects of global and national shocks, policy responses, and structural features of countries—including their linkages with the global economy through different types of trade and financial flows. For example, the role played by the global business cycle in explaining domestic cycles in different country groups (that is commodity exporters versus manufacturing goods exporters; debtor countries versus creditor countries) is a promising topic.
Macro-financial linkages. Another key area of future research involves a better understanding of the linkages between financial cycles and macroeconomic outcomes. This research program has become all the more important because we now have a better appreciation of the critical role played by problems in financial markets as motivating factors for macroprudential policy. However, the conceptual frameworks underpinning the problems and associated policy proposals are not well understood. There still remains a vigorous debate on the effectiveness of regulatory measures to cope with large fluctuations in asset and credit markets. More research on macro-financial linkages can improve our grasp of these complex issues and help guide the design of macroprudential policies.
Determinants of global financial flows. Global financial flows declined substantially in the latest global recession. Moreover, worrisome signs point to a significant slowing of the pace of financial globalization since 2008.8 For example, after growing at about 8 percent a year during 1990–2007, global financial assets have increased by roughly 2 percent annually since the global financial crisis. In addition, there has been a substantial decline in cross-border bank lending, and the process of financial development in emerging market economies appears to be stagnating. It is important to understand the sources of these financial trends and their implications for economic growth and macroeconomic stability.
Regional cycles. Our discussion of regional cycles around the episodes of global recessions and recoveries was limited to a set of basic stylized facts. It would be useful to extend this analysis and study channels through which regional cycles are affected by the global cycle, especially during periods of recession and recovery. This is particularly important in the context of regional surveillance efforts.
Recessions and downturns. It is important to present an extensive comparison between global recessions and global downturns. We just documented the basic features of these episodes here, but a more detailed study that provides a better characterization of the behavior of the global economy during global recessions and global recoveries could improve our understanding of how some downturns turn into global recessions while others have relatively mild effects. This could also enhance our ability to forecast the turning points in the global business cycle.
Collapse and Revival: The Enduring Reality
Considering the large and long-lasting macroeconomic, financial, human, and social costs associated with global recessions, it is natural that each episode creates fears of impending economic catastrophe. After each global recession, however, the world economy has been able to go through a period of revival and eventually recover. For advanced economies, however, the latest episode has played out quite differently so far. Most of these economies have been struggling with lackluster growth and experiencing unprecedented policy challenges since the end of the 2009 global recession.
There have been occasional pronouncements that the business cycle has been eliminated, especially during periods of prolonged stability and prosperity.9 In the 1960s, for example, there was such a discussion as the global economy enjoyed a long expansion. At the end of the 1980s, some observers argued that the business cycle was disappearing as the world economy had experienced an extended period of uninterrupted growth. During the late 1990s, the idea was popular again as some commentators bravely declared the end of the business cycle because of the forces of globalization and changes in technology and finance. Such claims have been proven false time and again. The business cycle, national as well as global, is alive and well.
Our main message is that collapse and revival are unavoidable features of the global business cycle. If there is one recurring lesson, it is our fundamental need to develop better policy tools to mitigate the costs associated with collapses and accelerate revivals.