L-Shaped Recovery

What is an L-Shaped Recovery?

An L-shaped recovery occurs when an economy enters into a severe recession, with high levels of unemployment and close to zero economic growth. When seen on a line chart, the recovery looks like the letter “L.” During an L-shaped recovery, there is a sharp decline in economic growth led by a small upward slope representing an extended period of stagnant growth.

Understanding L-Shaped Recovery

From all the forms of recovery, the L-shaped recovery is the most damaging form of recovery. There is a rapid drop in economic growth, with a painstaking recovery period that lasts for a significant time.

Therefore, an L-shaped recovery is called a depression, and a key feature of the recovery is that resources are not allocated to fight the economic downturn. It means that many individuals will remain unemployed, and capital equipment will be unused.

Over the years, economists tried to debunk the reasons for an L-shaped recovery. Keynesian economists argue that increased saving and continuous economic slump leads to an L-shaped recovery. Therefore, the only way to escape prolonged suffering caused by such a recovery is through monetary and fiscal policies, which will actively start the recovery process.

Examples of an L-Shaped Recovery

Over the years, multiple economies experienced an L-shaped recovery, from the U.S. during the 2008 Great Depression and Japan during the Lost Decade. Both the examples are well known worldwide for their use of monetary policy and expansionary fiscal policy to tackle the economic burden.

The 2008 Great Recession (U.S.)

The U.S. saw its local housing market collapse, leading to the financial crisis in 2008 that plagued the domestic economy. The credit market was wiped out, which led to home foreclosures and bankruptcies of small and large businesses. In addition, the stock market took a massive hit, and unemployment peaked at 10% within the year.

During the recession, the U.S. government bailed out multiple banks and businesses, which caused the taxpayers over $700 billion. The bailouts were conducted through the Troubled Asset Relief Program.

In addition to the bailouts, the Federal Reserve initiated an expansionary monetary policy to rebuild the U.S. economy by adding $4 trillion to the financial system. Following the end of the Bush administration, the Obama administration started a fiscal program called American Recovery and Reinvestment Act, which added $831 billion in federal spending.

Due to the policies implemented by the Bush and Obama administrations, the US economy went from the slump experienced in the L-shaped recovery to a path of slow and gradual economic recovery.

The Lost Decade (Japan)

Japan’s Lost Decade is considered another great example of an L-shaped recovery. Until the 1990s, Japan was experiencing phenomenal economic growth, with the country achieving the highest gross national product per capita. At such time, investors were reaping the reward of their investments in the stock and real estate market.

However, due to the immense growth of the Japanese economy, the Bank of Japan was worried about an asset price bubble. To combat the price bubble, the Japanese central bank raised interest rates in the late 1990s. The move caused the local stock market to crash, and the country’s annual economic growth fell to 1.14% between 1991 to 2003.

In response to the economic crisis, the Japanese government would spend over 100 trillion yen over a decade in the form of economic stimulus. In addition, the Bank of Japan reduced interest rates to around 0% by 1999. However, the policies failed to lift Japan out of the economic crash, and the country suffered an economic recession for over a decade.

Related Readings

CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• K-Shaped Recovery
• New Keynesian Economics
• Unemployment
• W-Shaped Recovery
• See all economics resources