L, W, U, V – the alphabet soup of economic recoveries

The question I’ve been hearing from economists is what type of economic recovery will we experience when the worst recession since the 1930s is finally put to rest. And I find it interesting that the academics use letters of the alphabet - L, W, U, V - to describe the shape of economic activity when we come out of an economic slump.

Let’s look at the 'L’ first. An L shaped recovery is almost no recovery at all. The recession comes to an end, but instead of seeing improvement, the economy remains stuck near the bottom.

Fortunately, this type of recovery is something we have not experienced in the US, but the Japanese government was slow to react in the wake of the collapse in real estate in the early 1990s, and a lost decade of growth followed.

Policymakers in the US are keenly aware of what happened across the Pacific and are doing their utmost to avoid a repeat at home. I believe an L shaped recovery is unlikely.

That leaves us with the V, U, and W. The US economy has typically rebounded sharply following steep recessions – the V shaped bottom. See Steep Recessions and Subsequent Recoveries. Interest rates fall, tax cuts take effect, and pent up demand is unleashed after a bottom. This was definitely the case following the short but severe drop in output in 1958.

But we saw a U shaped recovery in the early 1990s and at the beginning of this decade following relatively-mild recessions. And the economy traced a W during the 1981-82 recession. This is sometimes called a “double-dip” recession because activity improves, then slips, before finally embarking on an upward path. When growth eventually picked up, the recovery was robust.

Despite the severity of this recession, which increases the odds of a V-shaped expansion, housing is still struggling and banks continue to deal with bad debt.

On the other hand, consumer confidence is rising, credit markets have improved markedly, and counter-party risk is receding. If housing corrects itself, the V may play out. Without a solid foundation in housing, a U or W seems more likely.