Aggregate Demand stimulus, TARP (Troubled Asset Relief Program) and or also called the bailout package helped to prevent the 2007-2009 US economy's downturn from becoming another Great Depression. Why was the stimulus-fueled recovery substantially weaker than expected?

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Aggregate Demand Stimulus Helped to Prevent the 2007–2009 Downturn from Becoming Another Great Depression. But Why Was the Stimulus-Fueled Recovery Substantially Weaker Than Expected?

In retrospect, it is clear that the U.S. economy was in a precarious position in 2006. Trillions of dollars had been borrowed to buy housing on the expectation that home prices would keep on rising. That expectation made borrowing seem like a “no brainer” as a potential buyer could anticipate that if she borrowed $200,000 to buy a house in one year, she would be able to sell it the next year for, say, $215,000. Selling at a higher price would allow her to pay off the $200,000 loan and keep the rest as pure profit.

Unfortunately, home prices started to fall in 2006. When they did, many people who had borrowed to buy houses found themselves unable to pay off their loans. That in turn meant that many banks found themselves holding loans that would never be paid back. Soon, many banks teetered on bankruptcy, the financial markets began to freeze up, and it became clear by late 2007 that the overall economy would probably enter a recession as the result of the housing collapse.

When it was widely recognized in late 2008 that the downturn was going to be unusually severe, public officials took extraordinarily strong steps to stimulate aggregate demand. In terms of monetary policy, the Federal Reserve lowered short-term interest rates to nearly zero in order to shift AD to the right by stimulating investment and consumption. In terms of fiscal policy, the federal government began the country’s largest peacetime program of deficit-funded spending increases. Those spending increases also shifted AD to the right by increasing the total amount of government expenditures.

Those actions were widely credited with preventing a much worse downturn. Real GDP did fall by 4.7 percent and the unemployment rate did rise from 4.6 to 10.1 percent. But those negative changes were much less severe than what had happened during the Great Depression of the 1930s, when real GDP fell by nearly 27 percent and the unemployment rate rose to nearly 25 percent.

As time passed, however, it became clear that the stimulus was having less of an effect than many economists had anticipated. White House economists, for instance, had predicted that the stimulus begun in 2009 would reduce the unemployment rate to 5.2 percent by 2012. But three years later the unemployment rate was still at 8.1 percent despite the Federal Reserve continuing to keep interest rates extremely low and despite the federal government continuing to run massive deficits to fund huge amounts of government expenditures. It took until late 2014 before the unemployment rate fell below 6 percent again.

GDP growth was also disappointing. Real GDP expanded by only 2.4 percent in 2010, 1.8 percent in 2011, and 1.6 percent in 2012. Through the end of 2015, real GDP growth never exceeded 2.5 percent per year. By contrast, the period after the early 1980s recession had seen annual growth rates as high as 7.2 percent per year.

One explanation for the disappointing unemployment and GDP numbers was that it was hard for the stimulus to be very effective given the high debt levels that were built up during the bubble years. The lower interest rates engineered by the Federal Reserve, for instance, were probably not much of an inducement for consumers to increase their borrowing when so many of them were already heavily in debt.

A related problem was that savings rates had risen. When the government attempted to use deficit spending and fiscal policy to stimulate the economy, policymakers were hoping that each dollar of government spending would induce many dollars of consumer spending. But debt-strapped consumers were devoting large parts of their income to making interest payments on debt or paying off loans. So, when stimulus dollars came their way, they often short-circuited the spending process by saving a lot rather than spending a lot.

Another issue was that the stimulus was diffuse while the sectors of the economy in greatest need of stimulus were focused. In particular, the government’s stimulus efforts shifted aggregate demand to the right. But not all sectors had been hit equally hard by the recession. Thus, when AD shifted right, a lot of the effect was felt in business sectors that hadn’t been hurt that badly during the recession. Meanwhile, many sectors that had been hit hard only received a small portion of the total amount of stimulus that they would have needed to see a full recovery.

A related problem was that in some sectors of the economy, the government’s stimulus may have resulted mostly in price increases rather than output gains. That is because the supply curves for many industries are steep. Consider dentists and jewelers. It takes many years to train competent dentists or skilled jewelers. So even if the demand for their services shifts right, there is a nearly fixed supply of dental services and jewelry services in the short run—meaning that any increase in demand will mostly cause higher prices rather than higher output. So when the government shifted aggregate demand to the right, certain sectors probably saw mostly price increases rather than output gains.

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