All the king’s horses and all the king’s men won’t be able to put the economy back together again.
That was the belief after the 2001 recession. The stock market bubble had collapsed, and the common view among economists and policymakers was that we would not be able to return to the high levels of employment we had experienced prior to the 2001 recession.
But Federal Reserve chairman Alan Greenspan wasn’t buying this line of thought. Many of his colleagues at the Fed were worried that any attempt to push the unemployment rate below the “new normal” of 6 percent, or thereabouts, to the 4 percent level that was normal prior to the recession would be highly inflationary.
Greenspan, however, noting the lack of evidence of any actual inflationary pressure, decided the Fed should push ahead instead of trying to slow down the economy as it approached 6 percent unemployment. And it turned out that he was right. We were able to reestablish the low pre-recession unemployment rates without experiencing inflation problems.
If the fall is permanent, then the new normal for unemployment will be in the 6 percent to 7 percent range.
We are having the same debate again. One of the most important questions policymakers face right now is whether the downturn in GDP that caused the recession is mostly permanent or mostly temporary. If it’s temporary – if we can put things back together again – then we will be able to return to pre-crisis levels of unemployment, or nearly so.
But if the fall is permanent, then the new normal for unemployment will be in the 6 percent to 7 percent range rather than the approximately four percent level that we were able to attain prior to the recession.
Which side is correct? The emerging view seems to be that much of the fall in GDP during the recession is permanent. If so, then we are already approaching the much higher unemployment rate that will prevail in the new normal, and hence there is not much more that policy can do.
But I am not ready to give in just yet. First, as Nobel winning economist Robert Lucas has argued, a look at the US from the late 1800s to the present shows that we have always bounced back before, and he believes we will do so again. Second, a look across countries shows that there is no set outcome after a financial crisis. In some cases, economies fully recover; in other cases, they do not, and it’s difficult to find systematic differences between the countries that can be used to predict which outcome will occur.