What Determines the Effects of a Recession?

In this post, I looked at the long-term effects of a recession. It examined the various short-term and long-term costs of recession (fall in output)

The impacts of a recession can vary depending on the type of recession and also the extent of the existing welfare state.

  1. Extent of Welfare state. The impact of a recession in the US tends to be greater than in Europe. Firstly, the US has no universal health care. A rise in unemployment is likely to increase the percentage of the population with no health care insurance. In European countries, unemployment doesn’t change the person’s access to health care.
  2. Cost of Education. An important concern is that a recession might affect long-term education standards. If there is a sharp fall in income, some people may not be able to afford an expensive college education. However, if there is free access to higher education, a recession may encourage more people to study rather than enter a difficult labour market.
  3. Labour market protection. In the US, the recession caused a more rapid increase in unemployment. In Europe, the rise in unemployment was correspondingly smaller. This is because the US had a more flexible labour market where it is easier to hire and fire workers. In Europe, unemployment was already higher; there is greater labour market protection making it more difficult to fire workers. The recession has seen US unemployment come close to Europe. But, in the recovery, US unemployment is likely to fall quicker than European unemployment.
  4. Extent of unemployment benefits. If unemployment benefits are low or non-existent, the cost of unemployment will be proportionately higher. If people see a dramatic drop in income, they are at greater risk of falling into homelessness or difficulties in finding suitable living conditions. This can make future job searches more difficult.
  5. Length of Recession. A short-lived recession is easier to ‘catch up’. Firms can merely delay investment decisions. Workers only face a short-term gap from the labour market. But, if the recession persists for more than a year, investment projects increasingly get shelved completely. In longer recessions, there tends to be a more permanent fall in output. It may be difficult to catch up with the long run trend rate of growth. Also, if unemployment persists for a long time, workers are more likely to become permanently discouraged and leave the labour market completely.
    Europe’s Lost Output

    source: Europe’s Gap – how a recession can cause output to drop behind trend rate.

  6. Type of recession. Similar to the length of recession is the type of recession. If it is caused by an increase in interest rates (UK 1991-92), it may cause problems in the housing market, leading to a substantial fall in house prices and rise in home repossessions.  However, these recessions tend to be quicker to be overcome because when interest rates are cut, the economy can recover. In the current balance sheet recession, there has been a significant fall in investment because of credit shortages. Therefore, there is likely to be a greater impact in the long-term.
  7. Speed of Fiscal Consolidation. In a recession, some governments may feel under pressure to deal with budget deficit quickly. This can lead to a sharp fall in government spending. This can adversely affect public investment and lead to lower economic growth. However, if governments are able to run a large budget deficit without rising bond yields, they can afford to maintain capital investment and avoid sharp and painful policies of spending cuts.


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