l-shaped-recovery

What is an L-shaped recovery? The L-Shaped Recovery In A Nutshell

The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Understanding an L-shaped recovery

The most important characteristic of an L-shaped recovery is a failure for the economy to revert to full employment after a recession. Controlling forces such as the government do not allocate enough resources to mobilize workers and increase business output, which means more workers are unemployed for longer and some may choose to leave the workforce entirely. By extension, factories, equipment, and other capital assets may sit idle or at the very least underutilized. 

The L-shaped recovery is considered to be the most severe form of recovery and is sometimes called a depression. The affected economy may take years or even decades to recover.

Examples of L-shaped recoveries

Here are some real-world examples of L-shaped recoveries:

The Japanese asset price bubble

Japan’s economy grew at unprecedented levels between the end of the Second World War and the late 1980s. After the asset-price bubble burst in 1992, deflation followed and the country experienced a long period of slow growth now known as The Lost Decades. The Japanese economy has not yet returned to the growth rates it enjoyed before the crash.

The Great Depression

Unemployment was as high as 25% after the stock market crash of 1929 in the United States. GDP contracted significantly and high unemployment persisted for over a decade, despite attempts by President Hoover to increase taxes and introduce federal funding for unemployment benefits.

The Great Recession

When the United States housing market collapsed in 2008, credit markets dried up and bankruptcies soon followed as unemployment rates surged to 10% the following year. The Bush and Obama administrations instituted a wave of expansionary monetary policy underpinned by new lending facilities and multiple rounds of quantitative easing, but unemployment remained above 5% until 2016. GDP growth was just 2.3% over the same period with the economy experiencing the slowest recovery since the Great Depression decades earlier.

What causes an L-shaped recovery?

To some extent, the causes of an L-shaped recovery are particular to the shock or crash that preceded it. The recovery seen after the Great Recession, for example, was caused by:

  • The inability of the housing sector to rebound after so many loan foreclosures.
  • The lack of financial support from the government, particularly in the immediate aftermath of the market collapse, and
  • The dire lack of available credit for consumers and businesses as banks diverted capital to repaying the large amount of debt they had amassed.

Having said that, the key determinant in whether an L-shaped recovery occurs is the shock’s ability to damage the supply side of an economy – otherwise known as capital formation. 

When the lending ability of a bank is diminished and the value of public and private assets does not grow, recovery is hindered and employee skills are lost as individuals exit the workforce. Productivity then decreases and the shock becomes structural.

Key takeaways:

  • The L-shaped recovery is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
  • Real-world examples of an L-shaped recovery include the Japanese asset price bubble, the Great Depression, and the Great Recession.
  • To some extent, the factors responsible for an L-shaped recovery are unique to the shock or crash that preceded it. However, whether such a recovery occurs depends on the shock’s ability to damage the supply side of an economy and its structure.

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