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ANALYSIS

A New Kind of Downturn Brings Head Winds That Could Weaken Economic Recovery

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By Neil Irwin
Washington Post Staff Writer
Monday, August 17, 2009

The wounded U.S. economy has shown signs of improvement in recent weeks. But many economists, who were caught off guard by the brutality of the downturn, are accentuating the negative, bracing for head winds that could cause the recovery to be weak.

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Huge swaths of the financial system have been damaged, which could lock consumers and businesses out of loans for years to come. American families are saving more and relying less on borrowed money. In this global recession, no part of the world appears poised to lead a buoyant recovery. And the U.S. government's aggressive stimulus efforts -- including special Federal Reserve lending programs and full-throttle government spending -- may need to wind down before the economy returns to solid footing.

Typically, a deep downturn is followed by a robust recovery, as happened with the steep recession of 1981-82, the most severe since World War II, which was followed by explosive growth through the rest of the decade. Many -- but not all -- of the world's top economists doubt that a boom will follow this time.

"Traditional economic models are built like a rubber band: You pull it hard and it will snap back," said Martin Neil Baily, an economist at the Brookings Institution. "I find it hard to see where that will come from in this case."

In other words, the downturn may be so severe, global and transformative that this time, the rubber band popped.

What's different now? This downturn was caused by a breakdown in the financial system, and in the wake of a massive housing and credit bubble.

Historically, recessions have come about when businesses over-invested or when the Federal Reserve aggressively raised interest rates. Once business inventories and staffing levels correct themselves, or once the Fed cuts rates, growth resumes.

Downturns caused by financial crises play out differently. The machinery of the financial system grinds to a halt; people cannot get credit to buy things and businesses cannot borrow money to expand.

According to an analysis of 14 financial crises around the world by economists Carmen M. Reinhart and Kenneth Rogoff, the unemployment rate rises an average of seven percentage points in a downturn (this one has increased the U.S. jobless rate by only 4.7 percentage points), and the crisis lasts an average of 4.8 years (this one is at the two-year point).

Growth spurts can emerge, and it appears increasingly likely that the U.S. economy will grow at a solid pace in the second half of the year, as companies restock depleted inventories. But it is unclear what would come after that, given the ongoing restrictions on credit.

U.S. banks have sustained massive losses already, and a wave of soured commercial real estate loans threatens to further limit their ability to lend in the year ahead. A bigger problem looms outside of banks -- in credit markets, which account for vast chunks of mortgage lending, consumer loans and commercial real estate loans. This shadow banking system remains dysfunctional -- notwithstanding a slew of programs the Fed put in place to get it going again -- and no one is sure when or whether it will recover.

All that makes it more expensive for people or businesses to borrow money -- if they can get a loan at all -- which could serve as a powerful brake on any recovery.


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