Booms, crises, and recoveries: A new paradigm of the business cycle and its policy implications

While academics and policymakers have been struck by the absence of recovery in the United States after the global financial crisis, we show all types of recessions, on average, not just those associated with financial and political crises (as in Cerra and Saxena, AER 2008), lead to permanent output losses. This fact has powerful implications for our concept of the business cycle and for macroeconomic and prudential policies to avoid and react to crises and recessions. A new paradigm of the business cycle needs to account for shifts in trend output and the puzzling inconsistency of output dynamics with other cyclical components of production. If output does not exhibit cycles, the rationale for constructing an ‘output gap’ as a measure of the cyclical position is not well justified and could generate misleading signals. The ‘output gap’ can be ill-conceived, poorly measured, and inconsistent over time.

Persistent losses require more buffers and crisis-avoidance policies, affecting tradeoffs in prudential, macroeconomic, and reserve management policies. Economic policies should be geared toward avoiding crises and severe recessions and responding with appropriate stimulus and safety nets. Financial regulation that contains excessive risk-taking and sustainable macroeconomic policies constitute the first best options. If these policies are insufficient, monetary policy may need to play a role in addressing financial stability risks. Where policy space permits, economic stimulus may also be helpful in the aftermath of a crisis or severe recession. Foreign exchange reserves can help insure against losses due to external payment crises. However, previous estimates of the optimal level of reserves assumed temporary losses. New estimates are required in light of the evidence that the losses associated with crises are persistent.

Beyond short-run output dynamics and stabilization policies, our analysis also points to a new model of long-term economic development. Poor countries have had more frequent crises and deeper recessions than rich countries over most of the last several decades. This volatility and its persistent adverse impact on output has held back poor countries’ development irrespective of any factors that support development as in the canonical model of gradual capital accumulation.