What Is an L-Shaped Recovery?
An L-shaped recovery is a type of recovery characterized by a slow rate of recovery, with persistent unemployment and stagnant economic growth. L-shaped recoveries occur following an economic recession characterized by a more-or-less steep decline in the economy, but without a correspondingly steep recovery. When depicted as a line chart, graphs of major economic performance may visually resemble the shape of the letter “L” during this period.
When referring to recessions and the periods of recovery that follow, economists often refer to the general shape that appears when charting relevant measures of economic health. For instance, employment rates, gross domestic product (GDP), and industrial output are indications of the current state of the economy. In an L-shaped recovery, there is a steep decline caused by plummeting economic growth followed by a more shallow upward slope indicating a long period of stagnant growth. In an L-shaped recession, recovery can sometimes take several years.
- An L-shaped recovery occurs when, after a steep recession, the economy experiences a slow rate of recovery.
- This type of recovery resembles the shape of the capital letter “L” when charted as a line graph.
- L-shaped recoveries are characterized by persistently high unemployment, a slow return of businesses' investment activity, and a sluggish rate of growth in economic output.
- They have been associated with some of the worst economic episodes throughout history.
- A common thread in L-shaped recoveries is a massive fiscal- and monetary-policy response to the preceding recession, which may slow the economy’s recovery process.
Understanding the L-Shaped Recovery
An L-shaped recovery is the most harmful type of recession and recovery.
The most important feature that defines an L-shaped recovery is a failure of the economy to progress back toward full employment after a recession. During an L-shaped recovery, the economy does not readjust and reallocate resources to get workers working and ramp up business operations very quickly. Large numbers of workers can remain unemployed for extended periods or even leave the workforce entirely. Likewise, capital goods such as factories and equipment may stand idle or underused for extended time frames as well.
Because there is a drastic drop in economic growth and the economy does not recover for a significant period of time, an L-shaped recession is often called a depression.
A few economic theories have been advanced as to why and how this can occur. Keynesian economists argue that persistent pessimism, underconsumption, and excessive saving can produce a prolonged period of sub-normal economic activity, and even that this is normal and there is no strong reason to expect the economy to be able to adjust and rebound on its own.
Others point out that L-shaped recoveries can typically be characterized as those in which monetary- and fiscal-policy interventions actively prevent the economy from adjusting and recovering from the losses of the preceding recession. These policies appear to ease the initial pain of recession and protect the financial sector, but slow the economy’s adjustment process.
L-Shaped Recovery Examples
Three major examples of L-shaped recoveries stand out in the last century of economic cycles: the recoveries of the Great Depression of the 1930s, the Lost Decade in Japan, and the Great Recession following the 2008 financial crisis. All three of these periods are well known for the massive campaigns of expansionary fiscal and monetary policy that were pursued at the time.
The Great Depression
Following the stock market crash of 1929, the U.S. entered the Great Depression, the worst recession ever seen. U.S. real GDP contracted sharply and unemployment rose to a peak of nearly 25%. Stagnant growth and high unemployment persisted for over a decade.
In response to the crash and recession, President Herbert Hoover increased both spending and taxes and ramped up unprecedented peacetime federal deficits, hitting a deficit of 4.5% of GDP during his term. Hoover led a concerted federal campaign to keep wages and prices from falling through the use of new federal lending subsidies, labor legislation, federal funding for unemployment benefits, and influential, though not technically enforceable, demands that businesses not cut workers' pay. The recession continued to deepen following these measures.
Expansionary monetary policy was also pursued through this period. The Federal Reserve cut the discount rate and purchased large quantities of Treasury securities to inject new liquidity into the banking system. Eventually, the U.S. would take the radical step of abandoning the gold standard under President Franklin D. Roosevelt to protect the interests of the financial system and facilitate more a expansionary monetary policy.
After the 1932 election, FDR extended and doubled down Hoover’s policies with fiscal policy involving ongoing annual federal deficits of 2-4% of GDP to fund massive public works projects and dramatically expanded federal regulation of economic activity. In the wake of these policies, collectively known as the New Deal, high unemployment and lackluster growth would extend the L-shaped recovery through the entire decade of the 1930s.
Japan's Lost Decade
What is known as the "Lost Decade" in Japan is widely considered to be an example of an L-shaped recovery. Leading up to the 1990s, Japan was experiencing remarkable economic growth. In the 1980s, the country ranked first for gross national product (GNP) per capita. During this time, real estate and stock market prices were quickly rising. Concerned about an asset price bubble, the Bank of Japan raised interest rates in 1989. A stock market crash followed, and annual economic growth slowed from around 4 percent to an average of just over 1 percent between 1991 to 2003.
In response to the crisis, the Japanese government would engage in 10 rounds of deficit spending and economic stimulus programs totaling more than 100 trillion yen through the decade. On the monetary front, the Bank of Japan cut interest rates over and over, approaching 0% by 1999, while accelerating the supply of new reserves to the banking system. During this time, Japan experienced what is now known as the Lost Decade. It failed to recover from the crash for 10 years and experienced the consequences of a slow recovery for another decade after that.
The Great Recession
With the collapse of the U.S. housing bubble and the financial crisis of 2008, the U.S. entered the now well-known Great Recession. As credit markets dried up, businesses failed and foreclosures and bankruptcies skyrocketed. The stock market crashed in the fall of 2008 and unemployment rose to a peak of 10.0% a year later.
In response to the steep recession that was underway, the Bush administration enacted a $700 billion taxpayer-funded bailout of the financial sector in the form of the Troubled Asset Relief Program (TARP). The Federal Reserve initiated an unprecedented and massive wave of expansionary monetary policy, including an alphabet soup of new lending facilities and several successive rounds of quantitative easing that injected $4.5 trillion in new bank reserves into the financial system. On the fiscal policy side, the Obama administration kicked off the American Recovery and Reinvestment Act, which brought $831 billion in new federal spending.
Subsequent to these massive campaigns of monetary expansion and deficit spending, the U.S. economy experienced the slowest recovery of the post-World War II era. Unemployment remained above 5% until the beginning of 2016 and real GDP growth averaged a sluggish 2.3% over the next several years.
How Long Do Economic Recessions Last, on Average?
Looking at data since 1857, the average length of recessions in the U.S. has been 17 months. This period has shortened somewhat in modern times—the recessions that have occurred since 1980 have lasted just less than 10 months, on average.
What Leads to an L-Shaped Recovery?
L-shaped recessions are long and pronounced, with a lengthy recovery period. A debt-based economy is a demand-constrained economy. This often happens following a credit crisis that stems from an overleveraged economy based on increasing amounts of debt. Growth is based on a demand-driven model in which households and firms borrow and spend their money. When credit dries up, as it does during an L-shaped recession, consumption and production plummet and the long process of de-leveraging must take place before growth can pick up again.
Why Doesn't Stimulus Work in an L-Shaped Recession?
Keynesian economics teaches that governments can use fiscal and monetary policy to prevent contractions in demand from creating too much pain and shrinking of the economy, but these policies can also create distortions that actually prolong the pain felt by businesses and consumers. They prevent the productive sectors of the economy from rebounding quickly and this creates chronically slow growth and high unemployment for a longer period. Economies based on debt require periodic crises of restructuring in order to correct imbalances in the economy and ensure a sustainable path back to growth. This restructuring is necessary because excess debt must be liquidated to restore the health of the financial system and allow growth to resume. Stimulus that makes money easier to borrow, however, can lead to more debt rather than less. Cutting taxes and lowering interest rates, can therefore counterintuitively prolong recessions.
The Bottom Line
Cases of an L-shaped recovery provide examples of economic policy responses that may have worked during the initial phases of a downturn but ultimately prevented the economy from recovering quickly, sometimes taking a decade or more to do so.
A wide range of macroeconomic variables have been shown to be significantly delayed following these periods of economic weakness, such as encouraging more borrowing via low interest rates and other incentives, even when the economy needs deleveraging. Many of these effects persist well after the policy interventions are withdrawn, suggesting that the damage is long-lasting. Moreover, analysis of Japan's experience suggests that these policy interventions ultimately could have severe long-term costs.