-- John Maggs, NationalJournal.com

After months where the main concern was to deal with the possibility of an outright collapse of the world economy, there are indications that we are approaching the bottom. The emerging debate between economists about the shape of the recovery is therefore timely. There are reasons for optimism – inventories are low and the resumption of world trade can act as a powerful accelerator - but experience with financial crises leads to circumspection: recent by BIS and IMF economists suggests that credit crunches and house price busts are linked to deeper and longer recessions, and that on average countries are unable to return to their previous growth path.

Taking stock over a smaller sample of four financial sector-induced recessions in OECD countries (Sweden, Finland, Japan and Korea), Bruno van Pottelsberghe and I have observed in a recent Bruegel Policy Brief that countries normally do not return to their earlier growth path. Labor markets hysteresis and the ineffectiveness of the normal Schumpeterian cleansing effect of recessions during financial crises explain this outcome. Importantly, strains in the banking system clog the virtuous reallocation of capital from ailing industries and firms towards new sectors and young growing companies. Productivity can therefore be affected.

However, there is variation in country experiences. It is during the recession that the seeds of future growth performance are sown – or not. Here the comparison between Japan and Sweden is striking: while the latter managed to accelerate its growth after the crisis and the recoup the entire output loss, the latter suffered a long slump often quipped the ‘lost decade’.

Policy therefore matters considerably and this is apparent along five channels:

-          the size of the stimulus packages,

-          their content,

-          labor market policies,

-          the restructuring of banks, and

-          innovation policy.

While the size of the stimulus has been widely debated, content is also important. In the EU national stimulus packages are often tilted towards the non traded sector. But the fear of ‘trade leakages’ often leads to put too much emphasis on demand to supply-constrained sectors. The Swedish experience also suggests that countries should not try to diminish unemployment by driving people out of the labor force. Keeping workers close to the labor market, through temporary work-sharing schemes may avoid the costly destruction of human capital. Most importantly, the banking sector should be swiftly restructured. It took seven years for Japanese banks to recognize half of its losses, but only three in Sweden. A ‘zombie economy’ is the worse threat to growth in the coming years. Finally, R&D should be supported. It is both highly cyclical and important for productivity in the next decade. A falling R&D today would translate into a lagging productivity tomorrow.

The answer is – the missing letter.  An L followed by a complete V.

Historical comparisons are especially problematic for this recession and the recovery to follow in part because we should probably think of current events as the second of three recessions.  The first recession ran from December of 2007 until September of 2008 and was fairly run-of-the-mill.  The second recession began with the financial implosion in September of 2008.  In the second recession, many of the forces at work in the first recession picked up additional steam, most notably the housing sector, but then the financial sector fell apart and with it the financing of much of the rest of the economy.

Another aspect making the current recession unusual is the extent of the damage to the financial sector, and yet another is that this recession is part of a global, synchronized recession in which many of our major trading partners are likely to fare far worse than will the United States.

With this background, and given the additional policy headwinds the economy is facing, dreams of a robust recovery before the end of 2010 are just dreams.  Among those policy headwinds are President Obama’s promise of higher tax rates on productive activity, additional upward pressures on interest rates due to at least a 50 percent increase in the public debt-to-GDP ratio, policy-driven uncertainties surrounding health care reform and cap and trade legislation, and then the unfashionable but inevitable economic consequences that would follow enactment of cap and trade legislation.

In addition, as the economy begins to recover, so too will fears and expectations about very rapid inflation given the Fed’s extraordinary response to date.  This will cause interest rates to build especially rapidly, choking off the recovery most especially by driving up the value of the dollar and making U.S. stuff less competitive in still weak foreign markets.  That’s the L; and then the V.

The Fed will have to pull out all the liquidity it has injected into financial markets.  If Bernanke can pull this off without triggering another sharp, deep recession, he’ll have made a good claim to the next 10 economic Nobel prizes.  He’s good.  Nobody’s that good.