Why Was the Last Recovery Slower Than Usual? Actually, It Wasn’t

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Recessions triggered by financial crises are almost never followed by quick rebounds. | Reuters/Shannon Stapleton

For years after the 2007 financial crisis kicked off a deep recession, many analysts were mystified that the recovery was so slow. It didn’t follow a traditional “V” shape, in which the rebound mirrors the speed and force of the downturn.

Some critics blamed President Obama’s economic policies, while others pointed to a weak global economy.

It turns out that both schools of armchair historians may have been wrong. A new study of financial crises going back to 1870, coauthored by Arvind Krishnamurthy at Stanford Graduate School of Business, finds that the recession of 2007–09 played out pretty much as expected.

Regardless of whether government policy was helpful or not, the study finds, recessions triggered by financial crises have almost never been followed by snappy rebounds.

That’s because a financial crisis is very different and more painful than a “normal” economic slowdown, such as the one spurred by soaring oil prices in the early 1970s. Recessions tied to financial crises, where major banks collapse and credit dries up, have historically been followed by slow and agonizing recoveries.

“It’s true that if you benchmark to a non-financial-crisis recession, the usual rule of thumb has been a V-shape — the deeper the recession, the faster the recovery,” says Krishnamurthy, who teamed up with Tyler Muir of UCLA. “But if you benchmark yourself to financial-crisis recessions, you get a different outcome and slower recovery.”

Credit Bubbles and Busts

If anything, Krishnamurthy says, the recovery that began in 2009 was quicker than the historical patterns would have suggested.

The heart of the new study is about the role of credit bubbles and busts.

As almost anyone who went through the financial crisis will remember, that collapse was preceded by an explosion of dubious mortgages and reckless financial practices. Banks and Wall Street institutions made trillions of dollars’ worth of risky home loans on amazingly easy terms. Remember “no-doc” mortgages, where borrowers didn’t have to document their income or assets? The banks, meanwhile, were themselves relying on trillions of dollars in overnight “repo” loans. It was a credit bubble that fueled a housing bubble, and it all crashed when borrowers began defaulting in record numbers.

As extreme as that was, Krishnamurthy says, the financial crisis and the sluggish recovery both followed patterns that were eerily similar to most financial crises going back to 1870.

In almost all those earlier cases, the researchers found, a financial crisis was preceded by a surge or bubble in easy credit — followed by big losses, a panicky reversal, and a credit crunch.

“Credit Spreads” as Yardsticks

Krishnamurthy and Muir tracked these boom-bust financial crises through changes in “credit spreads,” the difference between rates charged to low-risk and high-risk borrowers. Narrow spreads mean that risky borrowers, such as those with shaky credit histories or little collateral, aren’t paying much more than safer customers.

In the run-up to most financial crises, the researchers found, credit spreads usually became very narrow and the volume of lending ballooned. The crisis would begin when some sort of surprise, such as a jump in loan defaults, would scare lenders and prompt them to dramatically widen the spreads.

Wider spreads make it more expensive for many borrowers to get loans, if they can borrow at all. But the wider spreads also translate to big capital losses to the banks themselves, because they indicate that a bank’s existing portfolio of loans is riskier and less valuable than previously thought. As a result, the cost of borrowing spikes at the same time that a bank’s available capital is being shrunk by losses.

Krishnamurthy and Muir tracked much of this historical story by painstakingly collecting data on bond spreads from old periodicals, such as the Investors’ Monthly Manual.

The Lingering Burden of Debt Overhang

The researchers caution that their study doesn’t explain why financial crises make recessions so much deeper and recoveries so much slower.

But Krishnamurthy has a strong suspicion that the special burden of a financial-crisis recession is the “debt overhang,” a huge debt load that remains on households and financial institutions after their capital has been depleted by losses. Until people and banks shore up their balance sheets, which can take years, they will be hard-pressed to borrow, spend, or invest.

The researchers note that some financial shocks, such as the crash of the dot-com bubble in the early 2000s, cause a lot of financial losses but don’t lead to full-blown crises. One reason, they suggest, is that a financial crisis typically requires both a big relaxation in lending standards and an unusually big increase in total borrowing credit. That didn’t really happen with the dot-com bubble, but it did in the mortgage meltdown.

Krishnamurthy suggests that there’s some comfort in knowing that the great financial crisis wasn’t as unprecedented or mysterious as it seemed to many.

“I wasn’t sure if the recent U.S. crisis was a one-off case,” he says. “What the data confirmed to me is that what happened here fits right in with historical patterns.”