The recovery from the financial crisis of 2007‐2008 has been proceeding for 16 quarters, slower than every preceding recession with a financial crisis in U.S. history. Many have argued that the sluggish recovery reflects the severity of the financial crisis. Yet this goes against the record of U.S. business cycles in the past century and a half.
According to Nobel Prize winning economist Milton Friedman, “A large contraction tends to be followed by a large business expansion.” Friedman explained this tendency for a rapid bounce back from a deep recession by his plucking model. He imagined the U.S. economy as a string attached to an upward sloping board, with the board representing the underlying growth rate. Recessions were downward plucks on the string and recoveries were the string bouncing back—the greater the pluck, the faster the bounce back to trend.
In 2012, my colleague Joseph Haubrich and I studied whether business cycles associated with financial crises are different from the general pattern. Our analysis of 27 U.S. business cycles from 1880 to the present not only confirmed Friedman’s plucking model, it showed that deep recessions connected with financial crises recover at a faster pace than comparative recessions without them. We found that recessions tied to financial crises were 1 percent deeper than average and led to a 1.5 percent stronger recovery. Our findings differed from Reinhart and Rogoff because we defined a recovery as going from the trough to the peak of the business cycle while they defined it as running from the previous peak to the succeeding peak. They also used per capita real GDP and we used total real GDP. The recent recovery is much slower than historical averages after deep recessions, largely attributable to the unprecedented housing bust that accompanied the financial crisis.
Housing has been important in many cycles and there is considerable evidence that household investment leads the business cycle. The obvious question is to what extent problems in the housing market can account for the slow recovery. To answer this, we asked the counterfactual question, “What would the current recovery look like if it followed the historical pattern based on the depth of the contraction?”
We found that the most recent recovery stands out as particularly weak given the size of the recession. The shortfall attributed to problems in the financial sector was not able to account for the recovery’s slow pace. However, when residential investment was taken into account, the improvement was particularly noticeable in the recent recovery. Residential investment is not a large component of national expenditure but it is closely linked to the purchase of consumer durables and other housing-sensitive sectors, which stimulates consumption. The weak housing market stands out as a cause and an indicator of the recent, sluggish recovery.
The housing market has turned up sharply in the past year. Its turnaround likely reflects the operation of normal market forces aided by the Federal Reserve’s policy of low interest rates. Will housing’s performance turn the weak recovery into something more like a normal recovery?
We have too few observations to infer the answer to this question solely from regression results. But one way to look at this issue is to use the method developed by UCLA professor Edward Leamer in 2007 to predict the likelihood that the housing decline of 2006 would lead to a recession.
Following Leamer’s method, we calculated the abnormal contribution of residential investment to real GDP growth. Our results showed that if the recovery pattern in residential investment from the last few quarters continues its trajectory, then the current recovery should soon return to a more normal pace.
In the past several quarters housing has roared back from its slump. The boom in housing may indicate the end of the slow recovery. If this is indeed the case, the Federal Reserve should seriously consider ending its expansionary policy stance sooner, rather than later, and should focus on its exit strategy.
This past year’s housing sector turnaround should be a key factor in restoring the recovery’s back pace towards historical averages. The recovery could be slowed by a permanent rise in long-term interest rates but it is largely being driven by pent up demographic forces that were delayed by the recession.
This prediction holds constant other headwinds that may continue to prolong the sluggishness. Chief among these is uncertainty over fiscal and regulatory policy and the Affordable Care Act. There is also ongoing uncertainty about international developments such as the Euro crisis, slow growth in emerging economies and China, and turbulence in the Middle East.
Another major headwind is uncertainty over the Federal Reserve’s exit strategy. The debate over the tapering of bond purchases under QE3 and the opaqueness of the Fed’s Forward Guidance can only be detrimental to recovery. The housing upturn is a strong and significant medium term predictor of the economy’s return to health that must be seriously examined by the Fed. The Fed should be paying more attention to longer run fundamentals like housing than the weekly wiggles of the labor market in determining its exit strategy. The recovery in housing is a strong signal of the need to accelerate the exit strategy.
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Michael D. Bordo is Professor of Economics and Director of the Center for Monetary and Financial History at Rutgers University and a Fellow at the Hoover Institution.