So it was good news for everyone when the US economy began expanding in the summer of 2009, 19 months after falling into the recession that officially started in December 2007. Unfortunately, the recovery has turned out to be very anemic. Now, 15 months into the expansion, the level of real GDP is still lower than it was when the recession started.
Even more worrying, the rate of GDP growth has been declining almost from the start of the recovery. Real GDP rose by 5% in the fourth quarter of 2009, reflecting the end of the decline in inventories. GDP growth then fell to 3.7% in the first quarter of 2010 and to only 1.7% in the second quarter. The third quarter is shaping up to be much like the second.
This recovery has been much weaker than previous ones because of fundamental differences in the cause of the downturn and in the policies chosen to achieve recovery. Previous downturns were caused by the central bank’s efforts to reverse or prevent inflation by hiking short-term interest rates. When the central bank succeeded, it lowered those rates and the economy bounced back.
But this time the downturn was not caused by higher interest rates, and reducing those rates did not produce a strong rebound. This recession was caused by a mispricing of risk, leading to excessive leverage and high prices for a wide range of assets. When those price bubbles burst, households lost substantial wealth and financial markets became dysfunctional.
Because the downturn was not caused by high interest rates, lowering them could not lift the economy out of recession. The Obama administration therefore turned to fiscal policy – tax cuts and a range of spending programs. Unfortunately, the fiscal stimulus was not well enough designed to get the economy onto a strong, self-sustaining growth path. And, now that those stimulus programs are coming to an end, there is a danger that the economy will slide back into slow growth or even recession.