What Shape Will Recession Take?

Right now, the conventional wisdom seems to be that the United States is looking at a "U-shaped" recession and recovery. Output declined gently in the third quarter, is dropping sharply now and will continue dropping sharply in the first and possibly the second quarter of the New Year, finally bottoming out and beginning a slow recovery thereafter.

That’s the natural pattern that most recessions follow. However, this has been a pretty unnatural recession, with a number of highly artificial actions undertaken to fight it, meaning we must plan for the possibility that it won’t be a "U" pattern, but will instead follow a less-frequently seen pattern.

When you think about it, the alphabet presents a number of fun shapes, patterns or trajectories that an economic cycle might follow. There’s a slightly slanting J - a shallow downturn followed by an energetic, near-vertical upswing. There’s an L - a descent into the recessionary pit, followed by a total refusal to recover - kind of like an accident victim who flat lines on the way to the emergency room. There’s an O, round and round in circles, never going anywhere - you can think of that as being the typical pre-industry economy, without significant technological change.

When the Roman Empire collapses or the Industrial Revolution happens, you get a (possibly upside-down) Q, in which the economy escapes from the static O, to move down or up in the Q’s tiny tail. There’s an R - round in circles for a time, followed by a sharp descent into the economic mire: That’s static - albeit cyclical - economy, where some environmental disaster hits, causing output to tank.

There’s both the U and the V - the latter being an economic cycle where a slump is immediately followed by a sharp rebound, with no period of depressed activity at the bottom.

And of course there’s the W, the classic "double-dip" recession, like the one the United States experienced in 1979-82. W-shaped recessions can be further divided into two types: There’s the "lazy W," in which the second downturn is worse than the first; and there’s the "energetic W," in which a deep recession is followed by a shallower one that is barely a blip in a strong recovery.

The recession of 1979-82 was a slightly lazy W, whereas the 1929-41 Depression-era downturn can be thought of as a very deep energetic W, in which the second dip (1937-38) was still part of the same overall economic event, but was much shallower than the first.

Had the United States been on a gold standard with an administration determined to maintain budget discipline, the current unpleasantness - which started with a major banking crisis - would probably have followed a V-shaped trajectory. The banking crisis would have caused output to descend rapidly to a considerable depth. But once a bottom was reached, the U.S. economy would have recovered almost immediately, showing a period of extra-rapid growth as output returned to a normal trajectory.

That’s how it worked in pre-Keynesian gold standard days, when governments and business followed the downturn advice of onetime U.S. Treasury Secretary Andrew Mellon, who said it was wise to "liquidate everything." The economy might descend to an unpleasant depth, but once it turned, the forces that would fuel the recovery were very strong. Thus, the recoveries after the recessions of 1893-96 and 1920-21 were both exceptionally vigorous by modern standards.

Most modern recessions are U-shaped, rather than V-shaped. When a recession hits, governments run budget deficits while central banks lower interest rates and allow the money supply to expand. That limits the depth of the downturn, but it also reduces the speed of the recovery, since the natural stimulus from a smaller downturn is weaker, while the government stimulus wears off after a while. That’s what we got in 1991 and 2001; in the latter case, the U.S. government stimulus, both monetary and fiscal, was very strong indeed, so the recession was extremely shallow, but recovery was exceptionally slow.

In 1979-82, we had a W-shaped recession. The first leg was caused primarily by U.S. Federal Reserve Chairman Paul A. Volcker’s now-famous attack on inflation, in which he boosted interest rates well above their normal level, and choked off economic activity. That caused the first dip, which was ended by monetary relaxation. However, monetary policy was tightened again in late 1980, so we got a second dip, which was not balanced by the usual fiscal stimulus, and so proved to be quite deep. Being deep, the second half of the W was followed by a strong recovery from 1983.

This time around, both the initial banking crisis and the fiscal and monetary stimuli have been exceptionally strong. That raises the possibility of a W-shaped double-dip recession. Initially, the stimulus may act like a shot of adrenalin, causing the downturn to abort and be succeeded by what seems like recovery. However, the stimulus must inevitably be temporary, and will produce both extra-rapid money supply growth and an extra-deep budget deficit. That is likely to lead to a second downward leg, this time accompanied by unpleasant inflation, as the "hangover" from the excessive stimulus is felt.

Even more unpleasantly, we could see an L shape - "Bloody L," if you’ll allow me to use a British Cockney phrase, reflecting the unpleasantness of the outcome. That would result in a situation in which the ultra-low interest rates left in place too long fuel inflation, while out-of-control public spending produces deficits that permanently dampen growth, so recovery never really arrives at all.

That can happen: Japan in the 1990s had an L-shaped economic downturn, although with zero growth rather than a prolonged recession. More ominously, Argentina after 1945 transitioned quite quickly from a rapidly growing, buoyant economy into a global basket case, with occasional bursts of hyperinflation. That’s the worst-case scenario for the United States. It’s not likely, but neither is it impossible.

So what are we most likely to see? The factors causing short-term strength are currently powerful. The collapse in oil prices has caused retail sales to be considerably less weak than expected, stronger consumer confidence and leading indicators both point to an approaching economic bottom, and the stock market is up more than 10% from its November low.

Instead of a "worst" down quarter, the first half of 2009 may see a period of unexpected strength, with cheap mortgage money producing an apparent bottom in the housing market, a bottoming out and initial recovery in U.S. gross domestic product (GDP), and an additional bounce in U.S. stock prices.

Don’t be fooled if this happens (though by all means try and make a buck or two out of the short-term stock market bounce). The Obama "stimulus package" and massive federal government slush funds will exact a price - in the second and probably deeper leg of a lengthy lazy W recession - the much-feared "double-dip" downturn.

Original post

Comments

[MarvinMBA]

Why we continue to characterize the future or try to when we are absolutely in unchartered terratory. Forget about recession...were in a DEPRESSION and will not be out of it for 10 years...MarvinMBA

2008 Dec 26 04:46 PM

[dw57]

i think we will see an L unless the stimulus or some thing gets the economy off its back. we have lost to much of our economy for it to recover in a U or W or V even. and we will be lucky if the L isn't extremely long.

2008 Dec 26 05:49 PM

[beenburnedtwice]

After we are in this recessionary period for a couple of years it will begin to look normal. A much reduced standard of living than what we've seen in the last 4 or 5 years while bouncing off of double-digit unemployment, couple with anemic equity markets.

The shape will be almost flatline, with a slow pulse. The pulse beats will be that of unpredictable commodities price spikes.

Yes, the shape will be re-written, maybe the 27th letter of our alphabet, I'll call it: the symbol formerly known as retirement.

2008 Dec 26 06:07 PM

[investor88]

Not cheery prognostication as the world transitions to a lower debt, lower standard of living for a period maybe a decade long before things really improve?

2008 Dec 26 08:29 PM

[aarc]

The Dow Jones 100 year chart is defining an Expanding Flat pattern that started in year 2000.

Expanding flat patterns are very common in intraday, daily, weekly and monthly charts. MER is an expanding flat pattern on the monthly and quarterly charts that has a target of $9 that was already achieved since MER C-wave down started almost a year ahead of the Dow Jones.

Dow Jones is now defining the C wave of the ABC pattern that has basically completed the iii-rd wave of the 3rd wave of the C-wave and is in the process of completing the iv-th wave by Jan/Feb 2009.

Nominal C-wave target for Dow Jones is 4750 by H2 2009 with 5293 as an early potential buying target that may prevent it from achieving the nominal or usual target. Lesser probability target is an extended run to 2845 or even an over-extended run to the 700-1000 of the years 1965-1980 consolidation range. Over-extended run has a higher probability than the extended run. Extended and over-extended runs do happen but the nominal range is the most common pattern.

Expanding Flats are bullish patterns and the ensuing rally ussually consumes less than half the time of the whole pattern to complete and in most cases in less time than the B wave of the ABC pattern (years 2000-2002 is the A wave, years 2002-2007 is the B wave). In case of Dow Jones, the recovery rally should be less than 5 years.

The most common pattern is a V pattern after the C wave has completed. Common logic says that the recovery can be very fast since the C wave usually consumes massive acreage at an extremely short period of time (less time than the A wave) and is not capable in most cases to inflict debilitating damages to the company or the economy for that matter. C-wave is a panic sell-off brough about by the fear that has been induced by the most recent experience with the A-wave meltdown (the Tech meltdown of 2000 to late 2002 for Down Jones was still too fresh a wound for most investors forcing them to press the panic button at the very first sign of trouble).

In case of over-extended panic run (down to 700-1000 range); the probability of a complex combination pattern can extend the correction process that can consume considerable time in the order of 200-400% (meaning 18 years to 36 years) but not necessarily of higher probability than that of a V shape recovery. U shape patterns are very rare. W shape patterns are rarer still. L shape patterns are extremely rare and most often can occur during massive gap ups that usually happen to biotech companies when they discover new drugs or new drug approvals.

2008 Dec 26 08:32 PM

[scotty1560]

good analysis: I like a "W" or an "L". New Prez and lots of stimulous,
so I'm hoping for a "W" to buy some time!

Anyone that quotes Andrew Mellon rates high with me. Mellon was the
old school, kill the cancer, keep it simple, start over. Today's technical
guys just complicate everything to death, while not having the "resolve" to
do the necessary dirty work in re-setting an economy. Between the FED,
the treasury, de-regulation, tax codes, etc- I think we have distorted reality
about as far as possible. The old school guys payed cash for most items, had strong equity in a fixed rate mortgage, did not use credit cards. Today we are "encouraged" to do the exact opposite.


Worth repeating:
"That’s how it worked in pre-Keynesian gold standard days, when governments and business followed the downturn advice of onetime U.S. Treasury Secretary Andrew Mellon, who said it was wise to "liquidate everything." The economy might descend to an unpleasant depth, but once it turned, the forces that would fuel the recovery were very strong. Thus, the recoveries after the recessions of 1893-96 and 1920-21 were both exceptionally vigorous by modern standards. "

2008 Dec 26 08:44 PM

[Allah]

I vote for an L. Stimulus and innate optimism will offset worsening economic fundamentals to produce a flat line for the next year. Anyone who can claim to see beyond the near term outlook is a fool or a liar.

2008 Dec 26 09:03 PM

[Anthony Alfidi]

Try a \-shaped downturn on for size. That's a backslash, a good metaphor for all of the jobs in finance, housing, cars, etc. that are being backslahed out of existence.

2008 Dec 27 01:45 AM

[cabaretewilliam]

The best quote in the last weeks, on this site, "We are now using communism to rescue capitalism". In the former USSR, the governments got rid of all state owned businesses. In the USA the government is buuying them all up but only after they have been run into the ground as worthless. Brilliant!

2008 Dec 27 08:39 AM

[M-P]

I see an L or lazy W type recovery. I believe that consumption patterns will be muted and that there will be more savings. Most people remember the immediate past - it's more available and accessible to them cognitively (see behavioral finance literature). I'm thinking that for the next few years, many people will take on less leverage and save a bit more. As inflation starts to show its face, the economy will need to be slowed a bit and a "V" like trajectory will be at a lesser slope. After a few years, all bets are off in terms of moving to the apex of another bubble. Hopefully, we will have learned some lessons around leverage, risk, and unintended consequences.

2008 Dec 27 10:41 AM

[billp37]

Future economic predictions perhaps should consider

"A new study released this week highlights what experts have been saying for years: the U.S. faces significant risk of power brownouts and blackouts as early as next summer that may cost tens of billions of dollars and threaten lives.

The study, "Lights Out In 2009?" warns that the U.S. "faces potentially crippling electricity brownouts and blackouts beginning in the summer of 2009, which may cost tens of billions of dollars and threaten lives."

"If particularly vulnerable regions, like the Western U.S., experience unusually hot temperatures for prolonged periods of time in 2009, the potential for local brownouts or blackouts is high, with significant risk that local disruptions could cascade into regional outages that could cost the economy tens of billions of dollars," the report warned.

U.S. baseload generation capacity reserve margins "have declined precipitously to 17 percent in 2007, from 30-40 percent in the early 1990s," according to the study. A 12-15 percent capacity reserve margin is the minimum required to ensure reliability and stability of the nation's electricity system. Compounding this capacity deficiency, the projected U.S. demand in the next ten years is forecast to grow by 18 percent, far exceeding the projected eight percent growth in baseload generation capacity between now and 2016...."


www.utilityproducts.co...

I believe.

FOIL 9 at website heightened my awareness.

From what I read, and filter, there may be some SERIOUS energy shortages in the near future.

Economic slowdown, of course, could lengthen time to problems.

Energy and econ are areas of INTEREST, not of ABILITY or EXPERTISE,

Aka, speculation on my part.

2008 Dec 27 06:58 PM

[Teutonic Knight]

My guess of the shape, unfortunately, is going to be the most pessimistic of all comments so far. I think it would be something like an "L", followed by a string of connected but much smaller-sized "Inverted M", stretching all the way to perhaps 2025.

There is little precedent we could draw on. True, the 1837 Panic was due to excessive land speculation but the world political landscape and the conditions of America then were much different.

The Great Depression was perhaps the closest example, but then America was destined to be the next world leader, unchallenged. China at the time was still in the midst of the Warlord era, India a British colonial crown jewel, and Japan a feudalistic and authoritarian regional power.

Ironically, these three powers will cut deeply into that pie that America relies on for its rebounding from the current malaise.

After some 60 years of post WWI and WWII where we growed and prospered behind the line of destruction untouched, the time is ripe for real competition.

2008 Dec 27 09:33 PM

[ebworthen]

I have to agree with Teutonic Knight.

Everything about the current circumstances are unprecedented.

The majority of the population is off the farm, and not even producing real goods. Many are feeding off of subsidies, taxes, and largess of the "service" sector which has created money by pushing paper and numbers between databases and nothing else.

We are in for a big collapse, like we have never seen. Kondratiff Winter, Google it.

I'm not a cheerleader either way, just an oberver. I look around and think "where do they get the money?" and then "where does it go?" and realize the whiplash will be in poverty and war.

Wailing and knashing of teeth I'm afraid.

2008 Dec 27 10:18 PM

[investor88]

Roubini says bottom Dow 7k in 2009. Aarc says likely Dow 5k. Most experts and big money managers says THE BOTTOM has been reached, up from here.

Let the market tells us? Sounds logical but not easy to put this into practice.

2008 Dec 28 08:17 AM

[Teutonic Knight]

Whatever shape and size it might be I am more interested in the next big thing that the Capitalist would do after this fiasco. For that is what we could get rich (legally, ethically, and morally) by recognizing it early and riding on it.

After the "invention" of the Internet, there was the Dot.com bubble. After that came and gone was the Housing Bubble. So what next, what are the Capitalist up to now? Surely they couldn't let their big money sit in Treasuries earning 0% for very long. True the present situation is frightening as it implies the investment climate is dire, and is truly indicative of the first leg of a depression in my view.

Infrastructure? It could be but my inside tells me that this is more a government thing and the margin of profits is fixed, less likely to be of great interest to the Capitalist.

Solar Energy? Wind Energy? Again, it could be but once again my inside tells me that these are more akin to fixed-income utilities and are less attractive for the Capitalist who I believe are looking for something more clamorous and easier to hype.

China? India? These are old bets that their first appeals were gone.

So what would it be? Anyone? Let us get rich together.

2008 Dec 28 03:04 PM

[nmelendez]

Gold Bubble's turn.


On Dec 28 03:04 PM Teutonic Knight wrote:

> Whatever shape and size it might be I am more interested in the next
> big thing that the Capitalist would do after this fiasco. For that
> is what we could get rich (legally, ethically, and morally) by recognizing
> it early and riding on it.
>
> After the "invention" of the Internet, there was the Dot.com bubble.
> After that came and gone was the Housing Bubble. So what next,
> what are the Capitalist up to now? Surely they couldn't let their
> big money sit in Treasuries earning 0% for very long. True the
> present situation is frightening as it implies the investment climate
> is dire, and is truly indicative of the first leg of a depression
> in my view.
>
> Infrastructure? It could be but my inside tells me that this is
> more a government thing and the margin of profits is fixed, less
> likely to be of great interest to the Capitalist.
>
> Solar Energy? Wind Energy? Again, it could be but once again my
> inside tells me that these are more akin to fixed-income utilities
> and are less attractive for the Capitalist who I believe are looking
> for something more clamorous and easier to hype.
>
> China? India? These are old bets that their first appeals were
> gone.
>
> So what would it be? Anyone? Let us get rich together.

2008 Dec 28 11:07 PM