The three biggest recessions during the post-World War II era are the 1973-75, 1981-82, and 2007-present recessions.
In the current recession, real personal consumption expenditures have fallen almost as much as they fell during the 1973-75 recession. With ongoing deleveraging and a rising unemployment rate, an additional decline is possible in the Third Quarter. In addition, real gross private domestic investment has plunged by 32.1% from its previous peak. That is the largest decline during the post-World War II period.
As noted earlier, household deleveraging is likely to place a lid on potential growth in personal consumption. The current recession differs markedly from the two earlier recessions cited above in that household and nonfinancial corporate leverage was substantially greater than it was during the 1973-75 and 1981-82 recessions.
The notably greater nonfinancial corporate debt could dampen a recovery in gross private domestic investment at a time when personal consumption is likely to play a smaller role in the upcoming recovery than in the recent past. In the 1973-75 and 1981-82 recessions, real personal consumption expenditures returned to their pre-recession peak two quarters after bottoming out.
This time around, a less robust recovery in real personal consumption expenditures is likely, even as real personal consumption expenditures accounted for a much larger share of real GDP than during the 1973-75 and 1981-82 recessions. It is plausible that it could take 3 or even 4 quarters from the bottom for real personal consumption expenditures to return to their earlier peak.
That means that gross private domestic investment, a reduction in the nation’s trade deficit, and increased government spending will need to lead the way to a sustainable economic recovery. However, the higher level of corporate indebtedness suggests that the recovery in gross private domestic investment will likely be a gradual one. Furthermore, given the high level of mortgage debt, the residential construction component of real gross private domestic investment, which has fallen 56.9% from its peak, is also likely to be slow. As a result of those two factors, the 1973-75 experience in which it took 8 quarters from its trough for real gross private domestic investment to return to its earlier peak is probably more likely than the 1981-82 experience in which it took just 4 quarters. An even lengthier recovery period is plausible.
A continued unwinding of the U.S. trade deficit should help strengthen the recovery, once it gets underway. However, the overall impact of this unwinding will likely be modest, if a global recovery pushes up the price of crude oil over the next 12-24 months.
Given the federal government’s unprecedented budget deficits, the recent massive expansion in federal spending is not likely to be sustained. Maintaining the aggressive fiscal posture could undermine investor confidence in the U.S. government, driving down the foreign exchange rate of the U.S. dollar, and generating a rise in long-term interest rates that could impede economic activity. In addition, with the IMF recently highlighting the medium-term fiscal challenges facing the U.S., namely the need to establish a credible fiscal consolidation strategy, efforts to curb the growth of federal expenditures could get underway in a year or two.
In sum, restrained growth in personal consumption, a slow recovery in gross private domestic investment, and limits to an expansionary fiscal posture will likely cap the rate at which the economy can grow. In turn, a slower growth trajectory could weaken revenue growth for the federal government, making it even more necessary for its developing and implementing a credible fiscal consolidation strategy. Given that challenge, it is quite likely that a combination of discretionary spending reductions and revenue increases will be deployed in any effort to cut the nation’s budget deficit. The extent of the tax hikes could have a material impact on economic growth.
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