Why is the recovery so agonizingly slow?

Last Friday's employment report underscored just how slow the recovery from the Great Recession has been. When the recession officially ended in June of 2009 the unemployment rate stood at 9.5 percent, and it peaked at 10 percent a few months later. In the four and a half years that have passed since, the unemployment rate has fallen to 6.7 percent. That is still quite a bit above the full employment level, and the fall in unemployment over that time period has been driven in large part by people leaving the labor force rather than the creation of new jobs. When these discouraged workers are taken into account, the labor market is in poor shape even after more than four years of "recovery."

Why has the recovery been so slow?

Type of recession: Recessions that are driven by a collapse of the financial sector, balance sheet recessions as they are known, are one of the most difficult types of recessions to recover from. That is because the collapse of the financial sector does great damage to the balance sheets of individual households. In the most recent recession, the typical household lost a considerable amount of home equity when the price bubble popped, stock values declined causing losses of retirement, education, and other types of saving, and widespread unemployment and underemployment caused households to use their accumulated saving just to survive month to month.

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One of the biggest mistakes policymakers made in responding to the recession was the failure to recognize early on that this was not an ordinary recession requiring standard policies. And even after it was recognized that this was a balance sheet recession, policymakers did not do anywhere near enough to help households rebuild what they had lost. We went to considerable lengths to rebuild bank balance sheets, and this was successful, but households did not receive the same attention.

Fiscal policy: The failure to recognize what type of recession we were experiencing and shape policy accordingly was not the only recovery-slowing mistake that fiscal policymakers made. The stimulus package was too small, tilted too much toward tax cuts instead of infrastructure spending and job creation programs, and there was no follow through when it was clear more stimulus was needed. To make matters worse, instead of providing adequate stimulus over an extended time period, Congress actually turned to austerity and sequestration — budget cuts — when just the opposite was needed. The recovery could have been much faster if fiscal policy had helped rather than hindered the recovery.

Monetary policy: Monetary policy performed much better than fiscal policy, but there is still room for improvement. In the critical early years of the recession the Fed was slow to recognize the severity of our economic problems, and late in providing the necessary monetary stimulus. The Fed mostly reacted after problems were evident rather than anticipating and forestalling them. And for a long time the Fed was inclined to see "green shoots" around every corner, and used this as an excuse to "wait and see" rather then be aggressive. The Fed has done much better lately, but improved performance in the early part of the recession could have made a difference in the speed of the recovery.

Automation: Although both have recovered slowly, GDP has recovered faster than employment. One reason for this is that firms are using the recession as an opportunity to replace people with machines. During normal times when firms are operating profitably, it's not easy to let a long-term employee go and replace him or her with a computer, robot, or the like. It may be someone you have worked with for years and years, a friend perhaps, and letting them go is difficult. But when a recession leaves you no choice but to let them go if the firm is going to survive at all, it is much easier to replace them with new technology during the recovery period. This slows the recovery of employment relative to GDP.

Distribution of gains: An under recognized factor in the speed of the recovery is the distribution of the economic gains during the recovery period. Profits and gains in financial markets have been strong, while wage growth has been weak to non-existent. The reason for this is the subject of passionate debate, is it technological change causing the rewards to skilled and unskilled labor to change, the decline in unions eroding away what little bargaining power wage earners had, globalization, robots, or something else? But whatever the cause, most of the income gains during the recovery have gone to a group of people that tends to have a high saving rate. Instead of spending the money mostly on consumption goods like working class households do, much of it is saved instead.

During normal times, that is not a problem since the savings are used to finance new investment projects. But in severe recessions when viable investment projects are much harder to find due to economic conditions, the savings piles up as retained earnings in corporations and excess reserves at banks. Had the economic gains gone to the working class and been spent on goods and services instead of sitting idle in corporate and bank coffers, the economy would have recovered faster.

Has the recovery actually been slow? In an absolute sense, this recovery has clearly been slow. It's been seven years since the recession started and four and a half years since the NBER declared the recession is over, and we still have a ways to go for a full recovery. But Carmen Reinhart and Kenneth Rogoff claim that in a relative sense — when compared to the recovery from financial crises in the past or to other countries presently — this recovery actually looks pretty good. For example, the U.S. has taken an average of 6.7 years to return to the pre-crisis peak in output following financial collapses in the past, but this time it has "only" taken six years.

But that is still far too long, and it doesn't mean the recovery could not have been even faster with better policy prescriptions. The average of 6.7 years comes from historical examples with less than adequate policy responses, so there is lots of room to improve. If fiscal policymakers in particular had done more to rebuild household balance sheets and stimulate the economy through infrastructure and other spending, we could have recovered much faster.

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