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Economy

Shapes of Economic Recovery

In order to understand the behaviour of the economic recovery from the COVID-19 pandemic, the different shapes of recovery has been a hot topic of discussion in most forums.

Howard Marks draws a beautiful analogy in his memo stating, “The government will provide life support to the economy during the coma and bring the patient out of the coma after the cure has been effected.”

The question remains, how would the world look like post this “coma”? Would we experience a steep upward recovery? Would we experience a period of depressed growth before a healthy return to normal levels of economic activity? Or would the world go under a severe painful extended contraction for years?

Shape of an Economic Recovery: This term is used to describe the contour of economic measures (think GDP, Industrial production, etc) when plotted on a graph to study recessions and subsequent recoveries.

EXAMPLES OF ECONOMIC RECOVERY SHAPES

U-SHAPE

When the economic activity and metrics associated with it namely GDP, employment and economic output experience a decline, remain depressed for months  and recover back quickly that’s called a U-shaped recovery.
Eg: The US recession of 1973-75, the onset was marked by the “oil shock” due to OPEC quadrupling oil prices, heavy spending on the Vietnam War by the US, followed by the stock-market crash in 1973-74.

V-SHAPE

When there’s a steep decline in economic activity followed by a steep recovery, it’s the best-case scenario in terms of celerity of recovery. When this sort of behaviour is charted it resembles a V-shape.
Eg: The US post-Korean War recession of 1953; this recession was onset by the government cutting down spending and tightening monetary policy with the intention to curb inflation rates spiking. This however led to consumer-sentiment taking a hit and demand dropping. It was a short-lived recession and the recovery was observed by Q4 of 1954.

L-SHAPE

This is the worst-case scenario in terms of economic recovery, when the decline in economic activity is steep and the subsequent recovery fails to pick up. Resembling an L shape when the economic growth is graphed. We shall visit a case-study on this in detail below.

CASE STUDY VISITED : JAPAN’S LOST DECADE

The phrase “Japan’s Lost Decade” is used to describe the period between 1991 and 2003, where the nation’s GDP grew merely by 1.14% annually. The contributing factors were the country’s real-estate and stock markets plunging by about 60-70% in the 90s.

The Story: The Japanese economy was growing at an enviable rate in the 80s. In order to control the rising inflation rates and asset prices the Bank of Japan adopted monetary tightening policies (increasing interest rates), which eventually triggered the equity bubble to pop. By 1991, there was a stark downward spiral in both equity and real-estate prices and the country had entered a Liquidity-Trap.

Source: Investopedia

So, while stuck in this “Liquidity Trap”, people hold onto cash and are reluctant to spend. Since one person’s expenditure, is another person’s income, decline in spending, translates to decline in consumption, which leads to a downward spiral in economic activity. While Japan did try to break out of this trap by adopting various fiscal policy measures like reducing taxes, spending on public infrastructure and printing money, the impact remained ineffective to revive the economy. Widespread illiquidity in the system coupled with a credit crunch contributed to a very painful phase for the Japanese Economy resembling an L-shaped recession.

And that’s a wrap for this week! Stay tuned for new articles every week, simplifying Finance for Gen A to Z.

Happy Learning,

Prarthana Shetty

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