Why is this Recession So Serious?

Photo courtesy of TonyTheMisfit (via flickr)

Photo courtesy of TonyTheMisfit (via flickr)

The average post-WWII US recession lasts eleven months, yet the current recession will likely be twice as long. The peak unemployment rate in post-war recessions averaged 7.6%, while we mentioned above that the unemployment rate in May 2009 was 9.4% and still rising. Why is the current recession longer and deeper than the norm? Part of this is illusory. The recessions in 1990 and 2001 were unusually mild, and the last major recession was in 1984. This implies that anyone under the age of about 45 has no memory of a serious recession.

That said, we can identify two reasons for the severity of this recession. The first is that the recession was caused by the financial crisis. Since all businesses.need financing to operate, the recession was not concentrated in one sector of the economy, but was felt by nearly all. Businesses fail during ordinary recessions because they don’t have enough savings or access to credit to stay in business while sales are down and their costs exceed their revenues. Since the current recession was caused by the financial crisis, credit was harder to come by than during normal recessions which magnified the number of business failures.

The need for credit is even more acute for businesses selling ‘big ticket items.’ These include residential and commercial real estate, motor vehicles, and other durable goods. Retailers often finance their inventories, and consumers often finance their purchases of these products. Constraints on credit, as happened during the financial crisis, cause dramatic decreases in sales of these products, leading to business failures.

Another reason for the long recession is the long recession. In other words, there are negative feedback mechanisms (“vicious circles”) that make things worse over time. For example, individuals might continue to spend at roughly the normal rate during a short layoff, but during a longer one, people realize they have to cut back to survive. Purchases of durable goods, in particular, can be deferred to the future. If one’s current auto is still running, it’s not hard to delay buying a new one for a year. Similarly, recessions affect the demand for imports, which spreads the slowdown globally, which comes back to harm the originating country through decreased exports. For each of the last two recessions (1990 and 2001), the recession was over before people even knew for sure we were in it. As a result, there was little opportunity for the negative feedback effects to occur. In the current recession, the financial crisis was so public and traumatic, and the government response so dramatic that by late 2007 consumers appeared to be very aware of the precarious nature of the economy. In response, they drastically cut back on their spending, as can be seen in Table 1. Businesses will not increase investment expenditures while consumers are not buying. Consumers are unlikely to increase their spending, while uncertainty about their future economic prospects is high. As a consequence, major recessions cause recessions to persist.

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