How Our Economy Recovers from Financial Crises

By Sean Masaki Flynn

An international historical examination of financial crises reveals that the economic recessionary periods that follow financial crises last several times longer than those following recessions that don’t involve the building up of massive amounts of debt. Here, you examine why the recovery from post-bubble recessions tends to take so long and why government policies that can work well against normal recessions have trouble speeding up the recovery process after an asset-price bubble collapses. Here are the two main culprits:

  • A weak banking system that can’t make many new loans
  • Structural mismatches between the goods and services that the economy’s existing firms are capable of producing and the goods and services that consumers actually demand in the post-bubble period

Enduring a broken banking system in a post-crisis economy

In the wake of a financial crisis, a nation’s banking system tends to be weak and unable to extend many loans. Many banks become insolvent and are forced out of business as the borrowers default on their loans. Other banks survive but are typically in weak financial condition because they made so many bad loans during the bubble.

As a result, the post-crisis banking system has very little capacity to make loans as the economy recovers from its post-bubble recession. The weak lending capacity prolongs the recession because even when consumers and firms regain confidence and want to borrow and spend again, they find very few banks willing to make loans.

By contrast, ordinary recessions tend to do very little damage to banks because ordinary recessions aren’t preceded by asset-price bubbles. When the economy is recovering from a normal recession, loans are usually much more widely available. This speeds recovery by allowing firms and consumers to borrow and spend more freely.

Struggling with structural mismatches in a post-crisis economy

Post-bubble recessions tend to be longer and more severe than ordinary recessions partly because of structural mismatches. An economy has a structural mismatch between its production capacity and the products consumers demand if the mix of goods and services that the economy’s firms are capable of producing differs from what consumers want to purchase and consume.

Post-crisis economies often feature structural mismatches because of distortions to productive capacity that occur while bubbles are expanding. For example, consider the United States housing bubble of 2000–2006 and the subsequent recession of 2007–2009.

The U.S. housing bubble of 2000–2006 was the largest real estate bubble in world history. During the expansionary phase of that bubble, credit was easily available throughout the economy. This led to $2 trillion of excess housing being built and to many firms’ borrowing trillions of dollars to fund new investment projects.

But even after the recession ended and the economy began to slowly grow again in the summer of 2009, unemployment remained very high and businesses were producing at levels far below their capacity. Some experts ascribed this to low aggregate demand caused by banks’ reducing lending and consumers’ reducing consumption in order to pay down debts.

Other experts, however, feared that the U.S. economy was suffering from a structural mismatch. Their reasoning was that during the bubble, firms had used their access to easy credit to build up lots of capacity to produce things that were popular during the boom — large new houses, fancy malls, and plenty of SUVs and large trucks. After the bubble popped, however, consumers didn’t want lots of new houses or new SUVs or additional large trucks. Instead, they wanted products such as iPads, better touch-screen cell phones, and smaller cars, as well as the ability to do more of their shopping over the Internet instead of driving to shopping malls.

If that interpretation is correct, then recovering from the 2007–2009 recession entailed a much slower recovery process than recovering from a plain-vanilla cyclical recession. The added difficulty came from having to rejigger the economy’s production capacity from making the products that were in demand while the bubble was expanding to producing the different goods and services in demand after the bubble burst.

Making that sort of a transition requires revamping old firms or starting new firms, moving workers away from dying industries into new industries, and undertaking the time and expense of retooling factories and restructuring supply chains. Making those adjustments all over the economy is not quick.

Noting the limits of government policy on economics

Whether a recession is preceded by a bubble or not, governments almost always attempt to use both fiscal and monetary policy to increase aggregate demand. However, government stimulus policies often appear unable to significantly speed up the recovery process after a financial crisis. The policies are stymied by the debt that remains after the bubble pops.

In particular, both fiscal and monetary policy are of limited effectiveness because post-bubble consumers want to deleverage, or get rid of their debt. Here’s how the desire to deleverage hampers both fiscal and monetary policy:

  • Fiscal policy: Post-crisis fiscal policy comes in the form of massive increases in government spending that are intended to stimulate aggregate demand by having the government purchase lots of goods and services. The hope is that by increasing people’s incomes, those initial purchases will spur further economic activity that will snowball into robust economic growth as consumers return to spending confidently.

But in the aftermath of a debt-driven bubble, fiscal policy’s stimulatory effects may be limited because people often use increases in income to pay down debt (instead of using the money to purchase additional goods and services).

  • Monetary policy: The government attempts to use monetary policy to stimulate demand by lowering interest rates to encourage both consumers and firms to borrow and spend more.

However, monetary policy fails to work very well after a debt-driven bubble because highly leveraged consumers are in no mood to borrow more money. They’re understandably more interested in paying down their current debts than in taking on additional debts.

If this situation sounds very dismal, it is. Until the debt level in the economy falls so that people do not need to devote so much of their incomes to paying off loans, economic growth is likely to remain stagnant, and government attempts at monetary and fiscal policy are likely to prove ineffective.