The Cost Of Austerity And Slow Recoveries

by: Antonio Fatas

What are the economic costs of business cycles? Economists tend to approach this question in a way that is very different from the way most people think about economic crises. The academic literature tends to think about business cycles within a framework where economic activity fluctuates around a trend. Within this framework, fluctuations are symmetric. Sometimes we produce "too little", some times we produce "too much".

Asking about the costs of economic fluctuations is equivalent to asking about the benefits of having a path for activity that exactly follows the trend, i.e. we eliminate volatility and we simply grow along a balanced-growth path. How much of a difference this makes is likely to be small. Because we are eliminating both periods of too-fast and too-slow growth, the benefits are only going to be second order through the reduction in volatility or uncertainty. Robert Lucas in his 1987 book estimated the costs of economic fluctuations to be as low as 0.1% of the steady-state level of consumption. While some of his assumptions were challenged by others to make uncertainty and volatility matter more, as long as we keep a symmetric view of fluctuations, their costs are likely to be small.

There is a different way of thinking about business cycles which better matches the way most people (not economists) think about recessions. Business cycles are asymmetric in nature. There are periods where we are growing at a normal rate and we are at full employment. These periods get interrupted by recessions (or crisis) where we temporarily produce below our potential. This view of the world, which is rare in the academic literature, was captured by Milton Friedman in 1964 by what he called the "plucking" model of business cycles. This description of business cycles is also not far from the Burns and Mitchell methodology adopted by the NBER, when establishing the dates of recessions for the .e.conomy. Below is a picture from a paper by Milton Friedman where he tested his model (in 1993).

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In this graphical representation, the cost of business cycle can be seen as the output that we lose while a recession is taking place -- i.e. the area between the trend or maximum level of output and the actual level of output. Because there are no periods where we produce above potential or trend, the costs of business cycles are likely to be much larger.

Together with Ilian Mihov, we have estimated the costs of all the recent recessionary episodes in the U.S. using this approach. In addition, we wanted to understand how costly a slow recovery was in some of these episodes. In our calculations, we remove the trend from GDP and look at data through the lens of the figure below.

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Recessions are defined by the dates provided by the NBER business cycle dating committee. We then produce a date for the recovery (that I discussed in a previous blog post) by assessing when the economy has reached potential or full employment. And then we can calculate the costs of a recessionary episode as the sum of the two triangles. In addition, we can calculate how much of the cost is due to the recession phase versus the recovery phase. One caveat before we show our estimates: in our analysis we are ignoring the possibility that the trend itself is also affected by the recession. If this was the case, we would be underestimating the true costs of business cycles.

Our estimates are summarized in the table below (more details in our paper).

Table 3. Cost of Recessions

(% previous peak annual GDP)

Recession Recovery Total
1948q4 4.29 2.56 6.84
1953q3 4.07 3.16 7.23
1957q3 3.30 2.60 5.90
1960q2 2.12 1.46 3.58
1969q4 1.07 1.00 2.08
1973q4 4.75 4.48 9.23
1980q1 2.05 2.73* 4.78*
1981q3 8.65 3.07 11.72
1990q3 1.27 2.89 4.15
2001q1 -- -- --
2007q4 5.54 16.57 22.10
The 1980 recovery is an unfinished recovery so costs are not comparable to the other recessions. The 2007 recovery is not finished yet.
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The cost is measured as the % loss in GDP compared to the level of GDP at the beginning of the recession (last column is for the total cost; the previous two columns decompose the total cost into the two phases, recession and recovery). We ignore the 2001 recession because it is too shallow and short to produce a reasonable calculation of its costs. The 1980 recession is special because the economy never recovered fully, so it is impossible to calculate its total cost. The 2007 recovery is not finished either, so the costs are calculated as of the end of 2012 (last observation included in our analysis).

Recessionary episodes are costly. In particular, the 1981 and 1973 events were the worst until the 2007 crisis with costs close or above 10% of GDP. The current episode is already twice as costly as any of the previous crises (above 20%).

The second lesson from the table is that the costs of a crisis used to be higher during the recession phase than the recovery. In other words, recoveries were fast. This is particularly the case in the 1981 episode. Despite this being one of the most costly events, most of the cost is coming from the recessionary period, the recovery was fast enough and not too different in terms of output loss than some of the other shallower recessions. This pattern has changed during the 1990 recession, and moreso during the 2007 crisis. The majority of the costs are now happening during the recovery phase. In 1990 the recovery phase was twice as costly as the recession (even if the overall cost was small). In 2007 the recovery is already three times more costly than the recession and it is not over yet. Why the current recovery is so slow is still a matter of debate, but as argued by many (including the recent work of Ayhan Kose and co-authors at the IMF) some of the blame has to be on the contractionary nature of fiscal policy (austerity) compared to previous events.

While there can be disagreements about the exact dates or the calculated costs we use in our study, what is clear is that an asymmetric view on business cycles is likely to generate significant costs of these recessionary episodes. In addition, these costs are becoming more skewed towards the recovery phase as opposed to the recession phase. This is an important fact that needs to be taken into account when thinking about the potential costs of economic crisis. The costs do not stop when the recession is over, we still need to go through a recovery phase, one that is particularly longer and painful in the current episode.