U,V,W,X,Y,Z…aka shape of recession and recovery to come

There is a lot of talk about what the shape of the recession and recovery will be. For better or worse, analysts typically use alphabet-based terminology to communicate their opinion and hence one can see a lot of headlines including the letters U,V and W (as well as L). So which letter will it be?

Let’s first start with what the letters refer to. In most situations - but not all, and partly not even dedicated Wikipedia page - analysts talk about the level of GDP or the level of output gap (rather than the growth rate of GDP). The letter then is meant to approximate the shape of the curve capturing the level of GDP over the recession and recovery period. So, for example, V-shaped recovery is meant to suggest that after steep drop will be equally steep immediate jump in level of GDP that will take us back to original level. All three of these aspects – steep jump, its immediate nature and reaching original level – are important feature of V-shaped recoveries.

While V-shaped recessions/recoveries were the norm historically, the recessions and recoveries in last few decades typically follow different script. First deviation is that the onset of recovery is less rapid. This means that rather the sharp edge of letter V we have the soft edge of letter U. In U-shaped recession and recovery a period of rapid decline is followed by period of subpar growth before recovery gets under way. Second deviation is assuming that the level of GDP is permanently lower due to the recession, probably thanks to recession destroying some productive capacity (e.g. bankruptcy of otherwise profitable firms or permanent loss of some human capital). In such situation the shape does not have the second half and we talk about an (tilted) L-shaped recovery: after dropping there is no jump reversing the drop. Finally, in some cases the first wave of recession is followed by second recession immediately after, with the experience of southern European countries a recent example of such phenomenon. To such situations analysts refer to as a W-shaped recession.

Another modification of the shape of recovery – one especially relevant for current situation – focuses on symmetry of the recession and recovery. The U-shaped recovery implicitly implies a symmetry in the recession and recovery parts, which in other words means that the rise in GDP during recovery is as rapid as the decline was in recession. This will almost certainly not be the case in current situation with record-breaking speeds of decline observed during the lockdowns. So a different shape-metaphor has been proposed for our recovery: a Nike swoosh. In this shape the recession is rapid but recovery takes time as in U-shaped recovery, and hence the shape is not symmetric.

So which letter fits the current situation best? The answer is neither, since this recession and recovery will be highly unusual. First, the recession is more rapid than anything we have previously seen, among other things reflecting the fact that it includes a large supply-side component in form of government restrictions on economic activity. Relatedly, absent a second wave during summer, there is going to be jump in activity once the restrictions are lifted and/or people feel free to resume their life. This means that initially the recession and recovery will follow a clear V-shaped script, with drop in first and second quarters followed by jump in third. However, in all likelihood the jump in economic activity will be smaller than then the preceding drop, so that the level of GDP in third quarter will be below the level in last quarter of 2019, potentially substantially so. Afterwards, we will likely be in our normal recession, which can have both elements of U- and L-shaped recovery. Of course, W shape is a clear possibility in current situation given that we might experience a second wave later in the year.

How would one describe such complicated profile in a letter? One option is an incomplete V (or small v) recovery, with the dropping part of V longer than the rising part. Another option is referring to current situation as VU-shaped recovery, with the initial V-shaped profile followed by more gradual U-shaped recovery. Obviously, an incomplete-V and VU-recovery recovery just does not sound so good and in any case does not completely evoke the shape. To better describe the shape one might want to abandon the alphabet for world of mathematical symbols and refer to the recovery as (inverse) square-root sign: normal square-root sign has a smaller dip followed by larger jump; our current situation will have the opposite. (Depending on the author, this profile can also be meant by the reference to Nike swoosh.)

Now you might thing why is it important if we use the correct metaphor for the recovery in general, and why it matters that there is an element of V-shaped recovery in otherwise a U-,W-, or L-shaped recovery. The reason is simple: the effect on expectations and corresponding surprises. Many analysts nowadays talk back against expectations of V-shaped recovery, and partly rightly so, since complete V-shaped recovery is almost certainly not in the cards. However, this might lead to the opposite excess: by ignoring the fact that the recovery will have an element of V shape, readers might be surprised in summer to see positive economic numbers consistent with a V-shaped recovery and confuse them with signs that the recovery will indeed be a fully V-shaped. By building in expectations that there will be a large, but temporary jump in level of GDP followed by more gradual return to pre-pandemic levels, one will be pre-conditioned to read the summer and fall numbers with extreme attention to size of the jump. 

This is also partly related to the why growth rates will not be a useful representation of economic situation during the second half of the year: while in third quarter we are likely to see a very large positive growth rate corresponding to a large jump in level of GDP – growth which in some countries might match the decline in second quarter - the level will almost certainly remain well below the pre-pandemic value. The unsuitability of growth rates is further amplified by the changing base in the calculation of growth rate: a drop by 10% followed by increase by 10% leaves us 1% below the original value.

This discussion even has a political dimension: in absence of second wave the third quarter GDP growth will likely be record-breaking. Intriguingly, the release of the third-quarter GDP falls on October 30, 4 days ahead of the U.S. presidential election. Expect a lot of big tweets about the best economic performance in the history of the United States, or maybe even the universe.

P.S.: Below is chart illustrating V, U, and L recoveries (as well as combination of U and L). 

 

P.P.S.: Here is the newest OECS forecast for euro zone GDP - the blue line follows the incomplete-V (or as they say, half-way V) recovery.