The ABCs of Economic Recoveries

News outlets, political pundits, and even the occasional economist love to leverage letters to describe potential macroeconomic recovery options after the economy takes a dive. From the victorious “V-shape” to the nascent and troubling “K-shape”, here are a few ABCs of economic recoveries to consider:

The four most common shapes talked about: V, U, W, and L

The V-Shape

This is the recovery everyone hopes for. A “V-shaped” recovery involves a sharp decrease in GDP, following by just as sharp an increase. A recession in this scenario is short-lived, perhaps only the minimum two successive quarters of decreased GDP required to call something a “recession”.

What does this look like? Since economic growth is often driven by labor and capital, a V-shaped recovery could involve a short period where at least one drops significantly. A hypothetical mandatory lockdown across the country would drastically reduces the supply of labor, but it wouldn’t actually change the labor supply itself when the lockdown ends, nor would it affect the availability of capital (e.g. machines/factories/computers to make things).

The U-Shape

While many hope for a V-shaped recovery, the “U-shape” is perhaps more realistic. After a shock worsens the economy, it can take significant time to complete the process of recovery. As a result, the economy may slowly climb back to its previous point, with gradual gains in employment, money velocity, and GDP pointing to a healthier state.

From the previous hypothetical, if a lockdown expires but the reason for the lockdown hasn’t actually gone away, then demand for various parts of the economy may remain severely depressed, and more people may stay out of the workforce for longer (improving the unemployment rate in the short term based on how it’s calculated, but leading to stagnation when people have to return). In theory, it could take years for a full recovery.

The W-Shape

Whenever recovery begins to look like a V-shape, you’re going to get some caution about the risk of a “W-shape” materializing. Even though things look on track for a rapid recovery, a W-shape means that the economy ends up spiraling down after reaching a local maximum.

For a different example, consider an initial supply shock where solar flares short out a lot of infrastructure. Although a lot of capital and transportation systems are damaged, if the government planned well in advance, and enough production facilities have been safeguarded to replace these systems, the economy could be back on track at a V-shaped pace. If another crisis happens, whether that’s a repeat solar flare that knocks out all of the newly-replaced capital, or a different shock (perhaps a Category 5 hurricane hits the southern US instead, or a swarm of locusts eats most of the corn in Iowa), then the economy will be tumbling back down again.

The L-Shape

This shape just sucks. After a sharp shock, an “L-shape” implies that the economy stays far below its original level for a lengthy period of time, with near-stagnation of various measures of economic health. Oftentimes, these extended downturns are severe enough that they enter into the popular lexicon as “depressions” instead of merely recessions.

Whether a demand shock, supply shock, or both hurt the economy, something’s happened to severely change the landscape. The losers (and pyrrhic winners) of drawn-out conflicts who find themselves with a shortage of people, or a shortage of capital from land, machines, and supplies due to the carnage of war, provide a grim example of an L-shaped recovery.

The K Shape

So far, all of the above shapes think about the economy in aggregate, usually defining this by country, or even by world. However, the effects of a recession and the benefits of an economic recovery aren’t always equally distributed. This leads us to the final letter, and perhaps the most troubling one to contend with: the “K-Shaped” recovery.

In a K-shape, part of the economy will personally experience the equivalent of a V-shape recovery, where things do start rebounding quickly. Other people will not be as fortunate, seeing an extended period of little growth (and/or continued decline) in their facet of the economy. The COVID-19 crisis and recession may end up following this K-shape, as professional industries continue remote work with little disruption to output, but industries like restaurants, travel, and hospitality get squeezed to the brink from overwhelmingly less demand than planned.

Letters are good guides to simplify concepts for our understanding, but they are just heuristics; No recovery is going to perfectly match the past, and no real-world graph is going to perfectly trace an arbitrary path. In the end, we can always be optimistic for a V, and hope that we don’t take an L.

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