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Is the recession over? (II)
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By Gabriel Martinez, December 20, 2010 in Uncategorized

If the evidence that the recession is over is so clear (see my previous post), why are we still in “tough economic times,” as the hackneyed phrase has it?  Why are there so many unemployed resources?  Why are so many people out of work? 

To say, “the patient has stabilized” is not the same as to say that the patient is healthy.  Consider a country’s ability to produce.  This is given by the amount of people willing and able to work, the amount of machines, buildings, and tools available, the state of technology, etc.  These factors determine how much output can an economy produce at a point in time (at least without endangering price stability).  Here’s the CBO’s guesstimate for Potential Output (the maximum that can be produced without running into inflation).

If less output is produced than can be produced, people will be out of work, machines will be under-utilized, buildings will be empty, etc.  A comparison of potential output with actual output (which can be done pretty easily if you know how to manipulate FRED Graph) suggests that even though the economy might have found the bottom of the barrel, it is quite far from getting out of it.

Put differently: in the second quarter of 2010, real GDP grew by 3%, which is just as fast as the average growth rate between August 2004 and July 2006.  Back then unemployment averaged 5%; today it’s almost double that rate.

What this means is that it is not enough for the growth rate of GDP to have stopped falling or for it to have become positive.  To get out of the barrel, GDP has to grow much faster than the average “good years” growth rate.

(This actually understates the magnitude of the problem.  Potential GDP grows every year.  Technological progress does not keep still.  Competition is still a force.  Population – at least in the US – keeps growing.  Capital accumulation may have slowed down by is still positive.  The amount of production that would be necessary to bring back “full-employment” of resources is larger today than it was when the recession started.)

Typically, after a recession has ended GDP spurts up, led by businesses’ purchases of fixed capital (which we call investment).  Low demand for loans reduces interest rates; high unemployment ‘moderates’ wages; high vacancy rates keep rents down.  Businesses sense a buying opportunity: those that can afford it, snap up market share by jumping in early.  This has happened, to some degree, at the beginning of this expansion. 

The problem is that, proportionately to the size of the recession, even very robust private investment has proved to be insufficient.  In my next installment, I will discuss some of the factors behind this.

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5 Comments
Lee Trepanier on Dec 21, 2010 at 7:10 am

Perhaps the reason why the recession appears to be over is that economics is not able to handle microanalysis very well. That is, economics might be good at analyzing marco trends but does not address individual analysis well.

Gary Scott on Dec 22, 2010 at 3:33 pm

University of Virginia Political Scientist, Steven Rhoads, answers it this way: "Economists feel misunderstood. People notice only their showy, disheveled, and presumptuous half, macroeconomics, while their solid, elegant, better half, microeconomics, remains unseen. Thus one can find prominent economists calling microeconomics the Cinderella side of the discipline…" (Source: The Economist's View of the World, 1985)

Lee Trepanier on Dec 23, 2010 at 8:45 am

What I wonder is whether economists are able to account for both individual economic preferences and experiences and societial economics preferences and experiences simultaneously. There clearly is a disconnect between what individuals experience presently and what the economic data for society as a whole informs us. How do economists account for this?

Gabriel Martinez on Dec 23, 2010 at 7:28 pm

If I understand correctly, what you mean is that talking heads and the Fed say "the recession is over", but people still find it tough going.

My answer would be that this lack of connection between "personal experiences" and "economic reports" is based on a terminological misunderstanding. "Recession" is a decline in economic activity. Since activity is no longer declining, the recession is over. The economy is not shedding jobs at increasing rates any more.

(The patient is no longer getting worse, but he's not getting better either. He has stabilized.)

But the word "recession" is often misunderstood to mean "tough times". In that sense, it's not over. Economists speak of the existence of a "recessionary gap", which perhaps would be better expressed as "less-than-full-employment gap." The total number of jobs created by the economy is less than the total number of job seekers.

(Neglecting structural and frictional unemployment, as economists would be quick to point out.)

The economy may be generating enough jobs to keep the jobless rate steady, but not to reduce the unemployment rate. Let me explain. As you can imagine, the number of people who want jobs (the labor force) keeps increasing every year as the population grows. To keep the jobless rate steady (whether it is high or low to begin with), the number of new jobs has to equal the number of new job seekers.

During the ... contraction (Dec 07 - June 09) the economy destroyed jobs pretty quickly. Those jobs haven't come back. To reduce the jobless rate you have to make up for the jobs that were destroyed during the contraction.

This would require more than simply stabilizing the patient (via, say, massive liquidity infusions or safety-net expansions). It would require a return of business confidence ... that is, of conditions that would encourage entrepreneurs to risk their capital and their reputation.

Lee Trepanier on Jan 3, 2011 at 10:27 am

It seems to me that economics does a reasonable good job at explaining marco events but a poor one at individual's experiences. That is to say, economics can account for a recession but is unable to account for tough times. Or is there is branch of economics that deals with micro analysis, at the individual level, of how one explains economic reality?

about the author

Gabriel Martinez
Gabriel Martinez

I am Associate Professor of Economics and Chairman of the Department of Economics at Ave Maria University. I have been in the Economics Department since its beginning and have taught over fifteen different courses at Ave Maria University, particularly in the areas of macroeconomics, international economics, development economics, Catholic social teaching, economic history, and social philosophy. My two favorite courses to teach are Intermediate Macroeconomics and Markets, State, and Institutions.

My work is in the general area of international finance and open-economy macroeconomics, with a focus on developing countries. My dissertation focused on the 1999 economic collapse in Ecuador,using a combination of historical, theoretical, and empirical analyses. My paper on the role of deregulation, moral hazard, and overconfidence in the Ecuadorian financial crisis was published by the Cambridge Journal of Economics. Financial crises are a perennial topic, with causes that are complex and deep, inextricably intermingled with politics and ethics. My Ph.D. is from the University of Notre Dame.