Recession of 2009

(The title of this article reflects the fact that the full intensity of the recession did not develop until 2009 although it starts with a reminder of some of the events that triggered it in the course of the crash of 2008 )

Downturns in economic growth rates were apparent early in 2008, and the subsequent intensification of the financial crash of 2008 led to a general expectation of worse to come. The resulting loss of confidence by investors and consumers contributed further to the severity of the reduction in world economic growth, and it was apparent by the end of 2008 that the economies of the United States and several European countries had for some time been in recession. An impending collapse of the international financial system was averted by policy actions introduced in the winter of 2008, but credit availability had been only partly restored by the spring of 2009. The world's economic output is expected to fall in 2009, but assuming the restoration of credit availability in the course of 2009, a gradually recovery is forecast to begin in early 2010.

Supplementary material:

for definitions of terms shown in italics, see the glossary on the Related Articles subpage;

for forecasts and a summary of recent economic developments see the Addendum subpage;

for a sequential list of events with links to further information, see Timelines subpage; and,

for a selection of economic statistics see the Tutorials subpage.

Origins

Throughout the period from mid-2007 to mid-2008, the growth of the world economy was hampered by increases in oil and food prices, and by a crisis in the financial markets. Oil prices rose from $75 to $146 a barrel and food prices rose sharply, forcing householders to cut their spending on other products. On the financial markets, the subprime mortgage crisis developed into the crash of 2008, as a result of which the availability of credit to households and businesses was curtailed, leading to further reductions in household spending and business investment. In the nine months to the middle of 2008, the advanced economies had grown at an annual rate of only one per cent (compared with two and a half per cent in the previous nine months) and the growth rate of the developing economies had eased from eight per cent to seven and a half per cent. According to the OECD the US economy was by then already facing substantial difficulties. Households had borrowed at an unprecedented rate during the previous 15 years, and their saving rates had fallen nearly to zero as they increasingly relied on housing wealth to finance consumption. With the housing market suffering the severest correction for 50 years, household wealth was declining, and with credit conditions getting tighter, households had been forced to reduce their reliance on borrowing, and job losses and mortgage foreclosures were rising. The prospects of a recession in the United States and of severe reductions in economic growth elsewhere were becoming apparent when the world economy was hit by another shock. The failure of the Lehman Brothers investment bank in September caused am international banking panic that triggered an intensification of the credit shortage to the point at which the world’s financial system appeared to be on the verge of collapse. Massive financial support to their banks by the governments of the industrialised countries averted that collapse, but failed to restore the supply of credit to businesses and householders. By that time, demand reductions had led to reductions in the prices of oil and food, but the resulting relief of the downward pressure on demand was being outweighed by the mounting effects of the credit shortage. By the end of September the United States economy had been in recession for nine months with no apparent prospect of an early recovery and by the end of the year, most of the industrialised countries had suffered reductions in economic activity. After that it soon become evident that a world-wide recession was under way.

Recession in the United States

By early 2009, the United States economy was suffering from a severe lack of demand. Three and a half million jobs had been lost in just over a year and businesses were responding to falling demand by laying off workers or cutting back on their hours or wages, causing families to further reduce their demand and businesses to respond with yet more layoffs and cutbacks. The problem was being made worse by the inability of the financial system to provide the credit necessary for recovery, and the resulting "credit crunch" was causing more job losses and further declines in business activity, which, in turn, was adding more pressure on the financial system. Two and a half million families had faced foreclosure in the previous year, and the reductions in personal wealth resulting from the fall in house prices were causing further reductions in demand. Reports from the twelve Federal Reserve Districts in March suggested that national economic conditions deteriorated further during the reporting period of January through late February. Ten of the twelve reports indicated weaker conditions or declines in economic activity. The deterioration was broad based, with only a few sectors such as basic food production and pharmaceuticals appearing to be exceptions. Looking ahead, contacts from various Districts rate the prospects for near-term improvement in economic conditions as poor, with a significant pickup not expected before late 2009 or early 2010. The availability of credit generally remained tight. Lenders continued to impose strict standards for all types of loans, with scattered reports of further tightening and particular scrutiny focused on construction projects and commercial real estate transactions.

The international recession

World

The crash of 2008 had an adverse effect upon most of the world's economies, but in 2008 it was only the more vulnerable of the industrialised economies that seemed likely to suffer major downturns. By the spring of 2009, however, most of the world's economies were facing severely damage. The United States and United Kingdom economies had at first suffered more seriously than most because of collapsing housing and consumer credit booms but it soon became apparent that more serious downturns were threatening the economies of Japan and Germany. Neither had experienced such booms, but both had proved to be exceptionally vulnerable to reductions in foreign demand for their exports resulting from reductions in world trade (which is estimated to have fallen by 7 per cent in the 4th quarter of 2008) - and particularly trade in capital goods. Most of the other developed economies (except Spain and Ireland) were also relatively free of such problems, but they too were damaged by loss of exports. The economies of commodity-exporting countries in Eastern Europe, the Middle East and South America suffered mainly from falls in commodity prices, and some other emerging economies were also damaged by the withdrawal of capital inflows from the developed economies.

In April 2009, economists at the International Monetary Fund were forecasting a contraction of world output by 1.3 percent in 2009 as a whole, but with a gradual recovery during its second half, and a rise of 1.9 percent in 2010.

United Kingdom

The rapid growth of the British economy in the early years of the 21st century had been partly due to the success of its comparatively large financial sector and to the development of a comparatively vigorous housing boom, and those factors had a strong influence upon the impact of the recession that followed the collapse of the Lehman Brothers bank in the United States. Even before that collapse, some of its banks had been forced to make large writedowns because of their involvement in the subprime mortgages crisis and there had been a run on one of them , but the banking panic that followed the fall of Lehman Brothers, threatened the continued existence of the financial system. In October 2008 the British Government announced a £500 billion rescue scheme , including powers to take equity stakes in ailing banks and an undertaking to guarantee interbank loans. An impending collapse of the UK's financial system was averted, but the surviving banks adopted a policy of deleveraging that resulted in a severe credit crunch followed by a general economic downturn. In the second half of 2008 gdp fell by 2.2 per cent with falls in financial sector output and in housing and commercial investment. The effective exchange rate fell by about 20 per cent during 2008, but its effect was more than offset by falling overseas demand, and there was also a fall in exports. Early fiscal and monetary action was taken to tackle the growing recession . A fiscal stimulus amounting to 1.4 per cent of GDP was introduced by the November Pre-Budget Report, including a temporary 2.5 percentage point reduction in value-added tax and a bringing forward of £3 billion of capital investment, and by March 2009 the Bank of England had reduced its the bank rate from 5% to 0.5% and begun a programme of quantitative easing. The UK’s national debt had been comparatively low at the outset of the recession, but there has since been a large increase in the budget deficit, which is expected to rise to over 9 per cent of gdp by the end of 2009, mainly as result of the operation of automatic stabilisers. The government's policy was endorsed by the IMF, but was attacked by domestic critics and (at first ) by members of other European governments . The reduction of value-added tax appears to have resulted in an early boost to retail sales .

Germany

The international banking panic had an immediate impact on Germany's fragmented banking system and in October 2008 the government set up a fund to guarantee the banks' debts and provide for recapitalisation and asset purchases. Although there had been falls in national output earlier in the year, the government did not at first consider further action to be necessary, but by the end of the year a fall in exports signalled the onset of major downturn, and in January of 2009 it launched a major fiscal stimulus (amounting eventually to 3.5 per cent of gdp) that included reductions in income, and payroll taxes(starting in July) as well as industrial subsidies and infrastructure investments. Those discretionary actions together with the action of the automatic stabilisers were expected to increase the budget deficit to 7% of GDP by 2010. Forecasters expect the downturn of the German economy to be deeper than those of other major industrialised countries except Japan.

France

The government adopted a fiscal stimulus amounting to over 1% of GDP, including infrastructure spending, measures to relieve cash-flow difficulties for small and medium-sized enterprises, tax holidays for low-income households, increased unemployment compensation, and loans to the car and aircraft industries. Together with the operation of automatic stabilisers, these measures are expected to raise the budget deficit to above 8% of gdp by 2010

Iceland

Before the Lehman Brothers collapse in September 2008, Iceland appeared to be in an enviable position among the developed countries. It had a thriving economy, its government had a budgetary surplus, its banks had no toxic assets and its consumers had not indulged in any speculative bubbles. (Although Willem Buiter and Anne SIbert , believe that its banking model was not viable). A few months later its banking system had collapsed, its government was deeply in debt, its currency had suffered a 65 per cent depreciation, real earnings had fallen by 18 per cent, and its economy was facing a deep and prolonged recession. Those were the consequences of the impact of the international credit crunch on a banking system that had overseas debts amounting to almost ten times the country's GDP. Unable to roll over their debts, three of its largest banks had to be rescued by the government, and the consequent rise in national debt caused a flight from the national currency that made matters worse. A loan was obtained from the International Monetary Fund and recovery is expected during 2011 .

Ireland

A downturn in the output of the formerly booming Irish construction industry that started in 2007, intensified and developed into a full-blown economic recession in the course of 2008 and construction and property companies began to default on loans from the banks. News of their defaults made foreign banks and investors, that had been the banks' principal source of short-term finance, reluctant to risk further commitments, and a banking crisis developed. In an attempt to restore confidence, the Irish government undertook to guarantee loans to the banks, as a result of which it experienced a large increase in its budgetary deficit. The sums of money involved were so large by comparison with the country's GDP that foreign investors became wary of a sovereign default, and the government's ability to finance the deficit was threatened by a general loss of confidence. In April 2009, the government decided that the only way to restore confidence was to take steps to reduce its deficit - and took the extraordinary step of increasing taxation in the midst of a recession . As Paul Krugman has noted "the Irish government now predicts that this year [2009] GDP will fall more than 10 percent from its peak, crossing the line that is sometimes used to distinguish between a recession and a depression

Additional steps taken include direct purchase of stock in some banks and the establishment of the 'National Asset Management Agency' - essentially a government-owned bank that will buy toxic debt from six financial institutions - both steps aimed at improving their balance sheets and freeing up capital.

Japan

Japan has suffered a much deeper recession than the other large industrialised economies mainly because of its greater reliance upon exports of cars and high-technology products. Output was also restricted by a credit crunch and by the need to reduce high inventory levels .

Developing countries

According to a World Bank report published in March 2009, 94 out of 116 developing countries have experienced a slowdown in economic growth. Of these countries, 43 have high levels of poverty. To date, the most affected sectors are those that were the most dynamic, typically urban-based exporters, construction, mining, and manufacturing.

International coordination

A G20 summit meeting of the world leaders took place in Washington on 15th November, with the purpose of agreeing a coordinated response to the financial crisis. An ebook was published in advance, with the recommendations of an international group of twenty leading financial economists. They were unanimous on the need for Governments to take urgent action to recapitalise their banks, to guarantee cross-border bank claims, to restructure nonperforming assets, and to extend financial support for crisis countries. They were also agreed on the need for immediate, substantial, internationally coordinated fiscal stimulus, tailored to the circumstances of each country and taken with a view toward the impact on the rest of the world. There was also unanimity on the need to augment IMF resources immediately so that the institution has adequate firepower, and on the need to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.

Policy debate

Overview

As the recession deepened, budget deficits widened, mainly as a result of the operation of automatic stabilisers, but also as a result of discretionary fiscal stimuluses. A widening conflict has developed between those who fear that the resulting fiscal expansion may be insufficient to counter growing output gaps - and those who consider fiscal policy to be unnecessary or ineffective - or who fear the possibility of sovereign default. Among the first group were the Nobel prize-winners Paul Krugman , and Joseph Stiglitz . Among the others were the Chicago School's Eugene Fama, and a group of eminent British economists who argued that "occasional slowdowns are natural and necessary features of a market economy" and that "insofar as they are to be managed at all, the best tools are monetary and not fiscal ones".

The case for fiscal expansion

By October 2008, policy-makers in most industrialised countries had accepted that in order to avoid the development of persistent and unmanageable deflation such as occurred in the pre-war great depression, early corrective action would have to be taken, going beyond the necessary restoration of activity in the financial system. Most countries had long abandoned the use of reductions of taxation and increases in public expenditure to ward off economic downturns in favour of the use of interest rate reductions , but there were doubts whether monetary policy would be sufficiently powerful, or sufficiently quick-acting in view if the severity and imminence of the current deflationary threat. In the United States, in particular, the federal interest rate had already been reduced to 1 per cent - leaving little scope for further reductions, and banks there and elsewhere had become reluctant to pass on central bank reductions of interest rates.

The consensus view among economists, as expressed by the Chief Economist of the OECD is that :

Against the backdrop of a deep economic downturn, additional macroeconomic stimulus is needed. In normal times, monetary rather than fiscal policy would be the instrument of choice for macroeconomic stabilisation. But these are not normal times. Current conditions of extreme financial stress have weakened the monetary transmission mechanism. Moreover, in some countries the scope for further reductions in policy rates is limited. In this unusual situation, fiscal policy stimulus over and above the support provided through automatic stabilisers has an important role to play. Fiscal stimulus packages, however, need to be evaluated on a case-by-case basis in those countries where room for budgetary manoeuvre exists. It is vital that any discretionary action be timely and temporary and designed to ensure maximum effectiveness.

In its 2008 World Economic Outlook, the International Monetary Fund has also noted that fiscal policy can quickly boost spending power, whereas monetary policy acts with long and uncertain lags , and a 2009 IMF Staff Position Note demonstrates that an internationally coordinated programme of fiscal expansion, combined with accommodative monetary policies, can have significant multiplier effects on the world economy .

The case for fiscal expansion eventually gained near-universal political acceptance, and by early 2009, nearly all the G20 countries had introduced fiscal stimulus programmes .

The need for fiscal space

However, the IMF also advise that a fiscal stimulus can do more harm than good if it makes debt unsustainable, and suggest (in another note) that further stimuli should be confined to countries with more fiscal space to expand, such as the United Kingdom, China, France, Germany, and the United States , as compared, for example with Japan and Italy. In another paper they warn that a spread in fears of government insolvency could hamper recovery. A perceived risk that governments find it more convenient to repudiate their debt could lead to an increase in the cost of borrowing that could further add to government debts in an unstable "snowballing" effect. The IMF have noted some signs of an increase in such fears and, although the perceived risk is so far small, they consider it important that governments should reassure markets that fiscal solvency is not at risk by presenting their fiscal policies in medium-term frameworks that envisage a gradual fiscal correction as economic conditions improve.

Objections

Professor Eugene Fama of the University of Chicago argues that consumers do not respond to tax cuts because of awareness that they will eventually be paid for by tax increases (the argument known to economists as Ricardian Equivalence). He also argues that all forms of fiscal stimulus are ineffective because they merely move resources from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment (the argument known as crowding-out). Others have argued that the danger of incurring unsustainable debt , makes fiscal stimulus a risky option, especially for countries with high levels of national debt. There have been warnings of resulting disaster, even for countries with modest ratios of national debt to GDP. Another objection arises from the fear that expansionary fiscal and monetary policies would not be reversed in time to avoid inflation (that objection was expressed by the economist Allan Meltzer in the same issue of the New York Times in which the economist Paul Krugman was advocating a further stimulus in order to avert the danger of deflation ).