The Shape of Recovery: Is It a V?

By Simon Johnson

Yesterday, at the Peterson Institute for International Economics, Mike Mussa and I discussed - and debated - the likely shape of the US and global economic recovery. Mike has great experience and an outstanding track record as an economic forecaster. His view is that the entire post-war experience of the US indicates there will be a sharp rebound. Victor Zarnowitz apparently stressed to Mike, a long time ago, “deep recessions are almost always followed by steep recoveries.”

I completely accept the idea that a slow or L-shaped recovery for the US and at the global level would be something outside the realm of experience over the past 50 years. I would also suggest that the financial crisis in fall 2008, the speed of decline in the US, and the synchronicity of the slowndown around the world over the past 6 months has also surprised everyone (including most officials) who think that we are always destined to re-run some version of the post-1945 data.

I argued that the nature of our economy has changed profoundly over the past 30 years, and we are only now beginning to understand the consequences. There has been some pushback against the main argument of our Atlantic piece, which is that a (very modern) financial oligarchy has taken disproportionate economic and political power in the US (aside: “we’re just stupid” is not much of a defense; the people involved are very smart, so how exactly did they get to create stupid organizations with the power to blow up the entire economy?) But no one is seriously disputing (1) the financial sector has become very large, (2) it was able to take on risks that were massive relative to the system, (3) these risks were not well managed, to say the least. We have experienced the financial equivalent of Three Mile Island; you will never look at finance again in the same way.

What does this imply for shorter-run macroeconomic dynamics? Do conventional US-based macro models still apply in the same way? Can finance drive growth in the same way as it has over the past 20+ years? How easy is it to switch people and capital into new sectors, for example so growth can be more driven by non-financial technology development? To the extent that banking survives the waves of contagion that are apparently still with us (look at the CDS spreads for major US banks over the past few weeks; during the rally!), won’t bankers hunker down for a while and refuse to take risk - until the next bubble, of course?

I agree with Mike that fixing the financial system is often not necessary (or actually sufficient) for a rapid economic recovery, although in today’s situation I worry about the disruptive effects of current bank bailout plans in many countries. A fast recovery, particularly if combined with moderate inflation, would probably improve the banks’ balance sheets considerably. To me, fixing the banks - i.e., greatly reducing their economic and political power - is essential for all our futures, irrespective of when and how the economy recovers. We cannot allow the same kind of potentially system-breaking risks to be taken again, and we cannot assume that the solutions that failed in the past (e.g., tweaking regulatory powers) will work in the future. Next time, the banks won’t just be Too Big To Fail, they’ll be Too Big To Rescue - the fiscal costs if we let this happen again would likely be huge; where is it written that the U.S. will for all time have fiscal credibility and provide the world’s leading reserve currency?

The main short-term issue for the shape of our recovery is surely that balance sheets are perceived as damaged all around the world. Plenty of creditworthy consumers think they need to be more careful. Firms with sensible investment projects are worried about the future availability of credit. Governments have only a limited ability to engage in fiscal stimulus; almost no one ran a sufficiently counter-cyclical surplus during the boom. And policy responses in most of the G20 remain inadequate.

If we have created a more unstable financial structure, perhaps we have stepped back in time to the US in the 19th century, when downswings could take considerably longer (or recoveries were more likely to be L-shaped; look at the NBER’s data) than in the post-1945 period? Or have we become more like an emerging market not just in terms of the excessive power of finance and the ability of one overexpanded sector to bring us down, but also in terms of our broader macroeconomic dynamics?

Emerging markets do, it is true, often recover quickly from steep declines. But they usually achieve this through managing a large real exchange rate depreciation (i.e., the nominal exchange rate falls by more than prices increase), which produces an export boom. At the level of world economy, we cannot export our way out of this recession.

The PIIE event audio is available already. It was also recorded by C-SPAN; when I learn the broadcast details, I’ll add them here and also put on Twitter.

Comments

[mac.barron:]

Of late I find certain postsers on S.A. remind me of everyone's old pal Muhammad Saeed al-Sahhaf (a.k.a. Baghdad Bob). The former Iraqi Information Minister became notorious for his relentlessly bright and sunny accounts of the massive victory that Saddam Hussein's military was winning over the invading Coalition Forces during the opening weeks of the ground offensive.

Apr 08 01:30 PM

[CautiousInv...:]

Before we look forward, let's look back for a moment and take a quick read of GDP in the eight years leading up to the beginning of the current recession. If we exclude the estimated impact of mortgage equity withdrawals upon GDP, we are left looking at a period in which GDP grew at 1% to 1.5% and employment increases were anything but robust. This is hardly a solid economic foundation for a rapid recovery after suffering a major contraction.

Looking forward, the US consumer clearly can no longer function as the engine of global economic growth. There are two closely intertwined issues: household balance sheets and unemployment. Debt to income is too high and we are seeing an up-tick in the rate of savings and a reduction in borrowings. As expected the consumer is retrenching; in most economic recoveries, we see an improvement in housing along with an increase in purchases of durable goods. To the extent this happens, it will not be vigorous.

By some accounts we added only slightly more than three million jobs during the eight years of the Bush administration; we have lost slightly more than five million during the past fifteen months. In an economy in which consumer spending accounts for 70% of GDP, employment is vital and if we are to have a V shaped recovery the question must be asked where the new jobs come from and at what pace?

The financial sector has been a massive drain upon itself and the real economy. Citigroup is eliminating 50,000 jobs and until more is known about the sector's exposure to troubled assets and the real financial risks, I don't think there is anyway to assess the sector’s role in any recovery. Increased regulation, greater oversight and reduced leverage will reduce earnings, though. In the long-run this may be good; in the short-run, it will work against a V shaped recovery.

Another point to consider is the Federal Reserve has made it clear that their primary mission is price stability and that they are prepared to unwind the Fed balance sheet the moment pricing pressures are detected. For sake of discussion, suppose we see inflationary threats before a solid recovery is underway? Clearly, the Fed could cut short any V based recovery if the recovery contains seeds of inflation.

For these reasons, I think the odds favor a stumble along recovery with the distinct possibility of another recession brought on by the Fed reversing its policy of ZIRP and QE in the face of pricing pressures and/or deterioration in the value of the dollar.

Apr 08 01:47 PM

[dcb:]

By Ross Finley

LONDON (Reuters) - The recession chokehold that is gripping the world's richest nations won't loosen until late this year, and Reuters polls show the economic outlook has dimmed for 2009 despite a vigorous global stock market rally.

The polls of 250 analysts across the developed world also found that the threat of deflation remains the bigger risk over the next year even though a significant minority say they are worried that future inflation may be the bigger danger.

If inflation were to take off again, any nascent recovery, which most economists agree will be brittle, could be snuffed out by rising market interest rates and any required policy response from central banks.

But economists are convinced that spare capacity in the world economy after a boom and bust of historic proportions will keep price pressures low and rising unemployment will further rein in consumer demand and tamp down wages.

"What worries me more than this disconnect between economists' forecasts and the stock market is the disconnect between the stock market and the credit market," said Marco Annunziata, chief economist at UniCredit in London.

"The credit market is telling you that there is a lot of pain still in the financial sector and this will make any recovery very difficult and very slow."

The Standard & Poor's 500 index of leading U.S. shares rallied more than 20 percent from a trough in March although stocks have pulled back some in the past few days and still appear to be in a bear market.

But credit spreads still remain wide.

And no wonder, given that toxic debts polluting banks and insurers around the world could total $4 trillion according to a press report this week citing new forecasts expected to come from the International Monetary Fund.

About two-thirds of economists polled across the G7 think the threat of deflation like that Japan suffered during its "lost decade" was a more serious threat over the next few years than a resurgence in inflation.

BUT MUCH STIMULUS OUT THERE

The latest Reuters survey results were collected over the past week, both before and immediately after leaders of the 20 biggest economies in the world gathered in London.

Those leaders have collectively pledged over a trillion dollars to save the global economy although critics say that measures to clean toxic assets off of bank balance sheets don't go far enough and that could still threaten future lending.

The U.S. outlook is the most likely to brighten first as it was the first economy to plunge into recession thanks to a mountain of bad housing loans and arcane financial products attached to a one-way bet that house prices would only rise.

But for now, no growth is forecast until later this year -- and it is weak. Perhaps more worrying is the pessimistic outlook for the industrial sector, which often is the first sector to lead the economy out of downturns.

"The bottom clearly has not been reached, though the shocks are abating," said Donald Ratajczak, economist to U.S. broker and asset manager Morgan Keegan.

In Europe, the forecasts have darkened considerably for 2009 as a whole, even if private sector surveys have hinted that the pace of deterioration is slowing and a stabilization at very low levels may be at hand after the economy fell off a cliff.

The 16-country euro zone economy is expected to shrink in the first quarter by as much as it did in the dismal final months of 2008 and will barely grow in 2010. That compares to a more robust recovery forecast next year in the U.S.

One of the biggest threats to any recovery on either side of the Atlantic is the staggering rise in joblessness which appears to be accelerating. That could seriously dent hopes for any rebound in consumer spending.

"The increase in unemployment is likely to dampen consumer demand and will increase downside risks for inflation or increase still low risks of deflation in the euro area," said Juergen Michels at Citi in London.

There were downgrades across the board for growth in France, Germany and Italy compared with what economists had predicted at the start of the year.

Japan's economy has taken a body blow from the collapse in world demand and the prognosis is even worse. Unemployment is expected to hit a record high and the economy is now forecast to shrink for six consecutive quarters.

Canada's economy should fare more like the U.S. and begin growing again later this year, according to the poll, but economists downgraded their outlook from the last survey taken three months ago.

(FOR POLL DATA CLICK ON)

(Additional reporting by Pedro Nicolaci Da Costa in New York, Stanley White in Tokyo, Ka Yan Ng and Teresa Ruiz in Toronto, Nigel Davies and Jonathan Cable in London, Tamora Vildaillet and Vicky Buffery in Paris, Cirsten Pahlke and Brian Rohan in Berlin, Viviana Venturi and Gavin Jones in Rome, Polling by Bangalore Polling Unit; Editing by Stephen Nisbet)

Apr 08 02:47 PM

[dcb:]

not only that, but if you imply certain ways to fix the problem you get beaten down as a commie, or something. It really reminds me of the tactics of the right and Karl Rowe. Beat the other side down with insults, shoult louder, and repeat the half truth till you are believed. don't provide supporting data.


On Apr 08 01:30 PM mac.barron wrote:

> Of late I find certain postsers on S.A. remind me of everyone's old
> pal Muhammad Saeed al-Sahhaf (a.k.a. Baghdad Bob). The former Iraqi
> Information Minister became notorious for his relentlessly bright
> and sunny accounts of the massive victory that Saddam Hussein's military
> was winning over the invading Coalition Forces during the opening
> weeks of the ground offensive.

Apr 08 02:52 PM

[dcb:]

Federal Reserve policymakers lowered their economic outlook for the rest of the year at its meeting last month, suggesting that they may not be done taking unprecedented steps to try and jumpstart a recovery.

According to the minutes of the Fed's latest policy meeting, which were released Wednesday, the central bank said that gross domestic product, the broadest measure of economic activity, is likely to flatten out in the second half of 2009 and expand only slowly next year.

The Fed had previously forecast in January that GDP would start to recover in the second half of this year and that the economy would grow between 2.5% and 3.3% in 2010.

The minutes from last month's meeting also showed that policymakers were split as to how much worse the economy would get and what the Fed should do about it.

Some Fed members voiced fears of deflation, a broad-based drop in prices that can wreak havoc on the economy. Several policymakers wanted the Fed to pump up the economy by buying long-term Treasury notes, while others thought it would be better to purchase mortgage-backed securities.

In the end, the central bank took both steps. It agreed to buy up to $300 billion of longer-term Treasury notes over the next six months, and also announced plans to buy an additional $750 billion in mortgage-backed securities.

Those moves helped bring down interest rates, including mortgage rates, and helped feed a rally in U.S. stocks.

Apr 08 03:15 PM

[mrmillergd:]

I'd suggest that in the next decade there is no way we resume the secular bull period in the markets that we saw from 1982 to 2007. The only growth industry we see right now is in government. While government spending does reduce unemployment, it is by nature a less efficient allocator of capital becuase of political intervention.

Until the private sector identifies new industries that it sees as potential gold mines, there is no way the market makes new highs.

Apr 08 03:51 PM

[George Fiala:]

Stephen Roach has been writing Cassandra-like for years that a system in which the whole world is set up to produce things for the US consumer to buy, and to make sure it happens go on to lend us the money to pay for it is inherently unstable. The world has to re-balance, we (in the US) has to start selling to people poorer than us and we have to live on our accumulated wealth for a while as we invest to restart our export industries. This will takes years to happen, and when it's all done maybe we'll have a more stable system, albeit more equal.

So for now I say we are in for a long L, with the bottom of the L in a down position, but maybe after a decade or so, if we make the right decisions, we can be part of global system in which the wealth is shared and all are better off.

Writing this it seems like I'm describing a Utopia, but in a way I'd say it's somewhat similar to the situation in the early 1980s when Paul Volker pulled the plug on the economy to wring out inflation, setting of a couple of decades of relatively good times, but with the systemic flaws described above. Maybe this time we can get it completely right.

Apr 08 03:59 PM

[John Lounsbury:]

Good article and (in general) great comment stream.

mmillergd - - -

I think you may be right about the outlook for investors and also about the inefficiency of government in the allocation of capital, there is one fact I have uncovered in studying the Great Depression (article coming).

During the Great Depression the recovery of GDP was much more positive than the reduction of unemployment. This fact is difficult for me to interpret, so the article is not yet ready. I mention this because of your statement: "While government spending does reduce unemployment,..."

Apr 08 04:02 PM

[schlumpf:]

it is a \
\

Apr 08 04:18 PM

[tunaman4u2:]

How about a giant L for American jobs that are never coming back from overseas... These jobs wont come back as long as Americans need too much wages to support their debt unlike Chinese & Indian workers with little debt.

How about a giant L for home prices that won't be able to rise as long as everyone is accepting pay freezes, unions accept lower wages thus less monthly income for a bigger mortgage. Home prices will not get back to that level for a long time without fraud mortgages & high employment.

Maybe Wall street will have a nice V because they cut expenses "American jobs" & got so much bailout money

So its a double loser LL for Americans & a V for Wall St for now

Does the Wall St. V trump the LL or the otherway around in the long run?

Apr 08 08:14 PM

[TraderMom:]

I think the worst news have all come out. The market has digested them. But it does not mean that the market is going to go up from here. I do not see any big plunges either. The market is going to chop and might form a W in a very choppy way. So I will focus on day trading and or short swing(3-5 days). I am leaning toward to the bear side, I will try to open positions of 60% short, 20% long and 20% cash.

Apr 08 09:09 PM

[Plan B Econ...:]

Definitely not a V.

Here's what's going on:
- Debt deflation
- De-globalization
- End of disinflation
- Re-regulation
- Securitization liquidity disappeared

Total debt-to-GDP in the US is about 350%. This needs to be reduced before any long-term growth can resume. This must be done through inflation and/or bankruptcy.

Take a look at the debt-to-GDP chart:
www.planbeconomics.com.../

Apr 08 09:15 PM

[ozcutty2:]

Fed can print money to pay off the debt. Result = recovery, probably before the rest of the world!

Apr 08 10:12 PM

[Mark Bern:]

The truth is no one really knows the shape of the recovery. As a matter of fact, it may be too soon to even worry about the recovery. I'm not saying that we have to go down and make new lows, but I wouldn't rule it out either. But if we want to be really honest here, there are several more shoes about to drop: consumer credit has yet to drop (it strongly corellates with unemployment), while unemployment is a lagging indicator it appears to still have a long way to go (70% of CEOs in a recent survey are planning additional job cuts while 66% are planning further cuts in capital spending budgets), commericial real estate is about to drop off a cliff (occupancy rates are heading down at an alarming rate and a lot of CRE debt is coming up for refinancing at a time when such credit is scarce), residential real estate has not bottomed (housing values are expected to drop at least another 10-15% and distressed sales and forclosures have not yet peaked), home builders are in worse shape than everyone thinks even though their stocks seem to be holding up relatively well (everyone thought we had hit bottom when new housing sales dropped to an annual rate of 1 million since homebuilders don't turn a profit below that level; but when sales increased to a whopping 377,000 annual rate everyone got all excited - we still need a triple in sales to reach the proverbial bottom, how is this good?).

Then when reality sinks in that the PPIP is going to reduce toxic assets (if all goes perfectly) on bank balance sheets by almost 1/3 by using nearly another $ Trillion of taxpayer money we'll get excited again. How about the other 2/3 of toxic assets still left on the banks' books? I hope we all understand that the PPIFs that are created will file for bankruptcy in a few years. And what if we do? What are we, the people, going to do about it?

Well, we're just spectators watching as the Treasury raises the price of admission. Oh, but don't worry. You can pay it all back later. And, BTW, we're not done yet.

Someday the government really will simplify the tax code. They'll have us all prepare a listing of our income by sources and just attached a signed blank check. Who else can you trust, if not your government? (I do hope you recognize sarcasm.)

Apr 09 12:36 AM

[Jason Rines...:]

Commodities spiked in between the years of 1935-1937? I believe that was the culprit.


On Apr 08 04:02 PM John Lounsbury wrote:

> Good article and (in general) great comment stream.
>
> mmillergd - - -
>
> I think you may be right about the outlook for investors and also
> about the inefficiency of government in the allocation of capital,
> there is one fact I have uncovered in studying the Great Depression
> (article coming).
>
> During the Great Depression the recovery of GDP was much more positive
> than the reduction of unemployment. This fact is difficult for me
> to interpret, so the article is not yet ready. I mention this because
> of your statement: "While government spending does reduce unemployment,..."

Apr 09 01:20 AM

[General Pus...:]

The entangled web of CDO's and the impending downdraft of commercial real estate has not been absorbed. Stock markets are filled with retail traders with short term objectives, so those signals are suspect. Much of the stimulus seems to be postponing the harsh realities. Getting toxic assets off balance sheet or into the hands of speculators that are financed (with the same high leverage that got us here in the first place) by government sponsored debt is not the answer to the problem of the value of these assets.

I agree with those that are questioning the source of a recovery...it certainly won't be the US consumer. What other drivers are there to foster a longer term, more stable economy?

Apr 09 04:41 AM

[Old Trader:]

John,

It wasn't that long ago that the US had a so-called "jobless recovery".....in fact, two of them, a decade, or so apart?


On Apr 08 04:02 PM John Lounsbury wrote:

> Good article and (in general) great comment stream.
>
> mmillergd - - -
>
> I think you may be right about the outlook for investors and also
> about the inefficiency of government in the allocation of capital,
> there is one fact I have uncovered in studying the Great Depression
> (article coming).
>
> During the Great Depression the recovery of GDP was much more positive
> than the reduction of unemployment. This fact is difficult for me
> to interpret, so the article is not yet ready. I mention this because
> of your statement: "While government spending does reduce unemployment,..."

Apr 09 08:27 AM

[Asbytec:]

I used to be an L guy, but judging the rapid rallies of late, maybe we're in for a V type. That is, once inflation makes those MSB's the Fed will own actually worth something to someone other than the mortgage holder.

Apr 09 09:30 AM

[John Lounsbury:]

Jason and Old Trader - - -

Thanks for the suggestions. I'll try to follow up.

All readers - - -

There is a good article I read this morning by "The Black Swan" guy, Nassim Nicholas Taleb, in the Financial Times:

www.ft.com/cms/s/0/5d5...

There is a summary in this mornign's Daily Beast:

www.thedailybeast.com/.../

Prof. Taleb discusses his proposals to "fix" the financial system and prevent a reoccurrence. Many are similar to ideas discussed in SA comment streams and in Baseline Scenario articles.

Apr 09 10:30 AM

[Conan the B...:]

While the economy is in sad shape and quite likely to remain so. The Likelyhood of Negative GDP for years on end is totally unreasonable.

The Economy is in an L. The stockmarket could well be in a V. Forced liquidations, not unlike the Program Trading fiasco in 1987, cratered it, not economic News.

The current bounce forsees better Economic news in 2010. Or do all of you believe that $300 Bilion worth of Infrastructure spending will not help the Economy and GDP in the slightest?

Apr 11 06:39 PM