An unusual recession, a rapid recovery

Jul 11 JDN 2459407

It seems like an egregious understatement to say that the last couple of years have been unusual. The COVID-19 pandemic was historic, comparable in threat—though not in outcome—to the 1918 influenza pandemic.

At this point it looks like we may not be able to fully eradicate COVID. And there are still many places around the world where variants of the virus continue to spread. I personally am a bit worried about the recent surge in the UK; it might add some obstacles (as if I needed any more) to my move to Edinburgh. Yet even in hard-hit places like India and Brazil things are starting to get better. Overall, it seems like the worst is over.

This pandemic disrupted our society in so many ways, great and small, and we are still figuring out what the long-term consequences will be.

But as an economist, one of the things I found most unusual is that this recession fit Real Business Cycle theory.

Real Business Cycle theory (henceforth RBC) posits that recessions are caused by negative technology shocks which result in a sudden drop in labor supply, reducing employment and output. This is generally combined with sophisticated mathematical modeling (DSGE or GTFO), and it typically leads to the conclusion that the recession is optimal and we should do nothing to correct it (which was after all the original motivation of the entire theory—they didn’t like the interventionist policy conclusions of Keynesian models). Alternatively it could suggest that, if we can, we should try to intervene to produce a positive technology shock (but nobody’s really sure how to do that).

For a typical recession, this is utter nonsense. It is obvious to anyone who cares to look that major recessions like the Great Depression and the Great Recession were caused by a lack of labor demand, not supply. There is no apparent technology shock to cause either recession. Instead, they seem to be preciptiated by a financial crisis, which then causes a crisis of liquidity which leads to a downward spiral of layoffs reducing spending and causing more layoffs. Millions of people lose their jobs and become desperate to find new ones, with hundreds of people applying to each opening. RBC predicts a shortage of labor where there is instead a glut. RBC predicts that wages should go up in recessions—but they almost always go down.

But for the COVID-19 recession, RBC actually had some truth to it. We had something very much like a negative technology shock—namely the pandemic. COVID-19 greatly increased the cost of working and the cost of shopping. This led to a reduction in labor demand as usual, but also a reduction in labor supply for once. And while we did go through a phase in which hundreds of people applied to each new opening, we then followed it up with a labor shortage and rising wages. A fall in labor supply should create inflation, and we now have the highest inflation we’ve had in decades—but there’s good reason to think it’s just a transitory spike that will soon settle back to normal.

The recovery from this recession was also much more rapid: Once vaccines started rolling out, the economy began to recover almost immediately. We recovered most of the employment losses in just the first six months, and we’re on track to recover completely in half the time it took after the Great Recession.

This makes it the exception that proves the rule: Now that you’ve seen a recession that actually resembles RBC, you can see just how radically different it was from a typical recession.

Moreover, even in this weird recession the usual policy conclusions from RBC are off-base. It would have been disastrous to withhold the economic relief payments—which I’m happy to say even most Republicans realized. The one thing that RBC got right as far as policy is that a positive technology shock was our salvation—vaccines.

Indeed, while the cause of this recession was very strange and not what Keynesian models were designed to handle, our government largely followed Keynesian policy advice—and it worked. We ran massive government deficits—over $3 trillion in 2020—and the result was rapid recovery in consumer spending and then employment. I honestly wouldn’t have thought our government had the political will to run a deficit like that, even when the economic models told them they should; but I’m very glad to be wrong. We ran the huge deficit just as the models said we should—and it worked. I wonder how the 2010s might have gone differently had we done the same after 2008.

Perhaps we’ve learned from some of our mistakes.

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