LONDON, UK - Recessions are bad for living standards, in both the short term and the longer term. And because recessions are triggered in a number of ways, we can't recession-proof the economy.
Macroeconomic policy can, however, limit the economic pain they cause. But the legacy of the last recession has left policy underprepared for the next. This means that the adequacy of our macro policy framework should loom far larger in our economic debates than it does at the moment – particularly as there is a relatively high risk of another downturn in the next few years.
Technical recessions (where economic output contracts for two consecutive quarters) have come along roughly once a decade in the UK. With the current period of economic expansion now into its tenth year, there is therefore concern that we are nearer to the next recession than we are to the last. Of course there is no mechanical link between the passage of time and the onset of a downturn. That said, risks can build over time. And, in this context, the global outlook has clouded over the past two years with a number of obvious recession triggers.
Indeed, a simple model based on financial-market data suggests that the risk of a recession is currently close to levels only seen around the time of past recessions and sharp slowdowns in GDP growth, and is at its highest level since 2007. This matters.
Looking across the past five recessions, GDP has fallen by around four per cent on average from peak to trough. That's equivalent to a hit today of around £2,500 per household. Similarly, the average rise in unemployment over past recessions equates to around one million people. There is of course much variation around this average, and in thinking about what effect the next recession might have on living standards, the potential scale of the downturn is clearly central. But so too is the way in which the economy adjusts to a new lower output equilibrium.
Recessions can be triggered in a number of ways, with no two the same, and all of them bad. They often reflect developments abroad, though domestic circumstances can also be at play. What characterises recessions is a synchronised fall in spending across the economy. The economic pain caused by that fall in demand leads to higher unemployment (i.e. fewer hours of production), a drop in earnings (i.e. lower reward for each hour of work) or a combination of the two.
When the bulk of that supply-side adjustment manifests as higher unemployment, the effects are concentrated on a small group (with clear distributional implications). When the pay takes most of the strain, it results in a more generalised sharing of the pain.
Recent UK history tells us that the exchange rate plays an important role in determining the balance between these two forms of adjustment. When sterling adjusts sharply downwards, wages tend to take the strain; when it does not, unemployment spikes more markedly instead. A comparison of the past two UK recessions illustrates this point. In the early-1990s, GDP fell by 2.0 per cent and the value of the pound saw a sustained fall of less than 10 per cent. Unemployment subsequently jumped by over a million people, but real-terms pay growth slowed only marginally relative to the pre-recession trend.
In 2008-09, GDP plummeted by 6.3 per cent and the exchange rate fell nearly 30 per cent. Unemployment still jumped – by around a million (1.1 million) – but by much less than had been expected given the severity of the downturn. The period was characterised instead by a severe wage squeeze in which median hourly pay (adjusted for inflation) fell by arond 7 per cent between 2009 and 2014. This case-by-case variation should caution us against assuming that the next recession will necessarily feel like the last: unemployment may be at historically low levels today, but there is every chance that the next downturn – even if it is smaller in scale than the last one – causes it to balloon once more. But whatever form the economy's adjustment takes, it should also be clear that the effects of a recession can persist for many years.
GDP, unemployment and real incomes rarely fully return to the path they were on prior to the recession, and recession scars can mean some areas and cohorts find themselves permanently left behind. Policy response is therefore vital. Macroeconomic stabilisation policy – the use of macroeconomic tools, such as monetary and fiscal policy to offset fluctuations in economic activity – plays a crucial role in stopping a recession becoming much more severe. Without it, there is evidence that he severity of the recession may be magnified greatly. Indeed, effective policy works both by addressing the underlying causes of a recession, and by providing substantial and timely support to overall demand.
During the Global Financial Crisis (GFC) that meant direct action to resolve failings in the financial sector, along with large-scale policy stimulus. On the monetary side, that involved slashing the Bank of England's base rate (from 5.75 per cent in December 2007, to just 0.5 per cent by March 2009) and engaging in the previously untried policy of Quantitative Easing (with £375 billion of assets being purchased by the Bank).
On the fiscal side, the stimulus took the form of tax cuts (with VAT being lowered from 17.5 per cent to 15 per cent for instance) and spending rises – with subsequent unwinding during the long period of fiscal consolidation from 2010. Absent the policy support delivered in the immediate postcrisis period, GDP could have been 12 per cent lower after the recession – equivalent to over £8,000 for every household in the UK. Worryingly, however, policymakers are unlikely to be able to respond in the same way should another recession hit. On the monetary side, there is the very real constraint provided by the proximity of policy interest rates to zero: a base rate of just 0.75 per cent equates to much reduced room for manoeuvre.
(Image credit: BBC News).