As you might surmise from the conclusion of my previous post, I have been worried about the possibility of a second dip, a new recession beginning sometime in the next year or so, before the current recovery has had a chance to produce much improvement. I was surprised to read (hat tip to Mark Thoma’s twitter feed) that Macroeconomic Advisors is suggesting that there is no chance of a second dip. (I was particularly surprised because MA’s own estimates of the growth impact of the waning fiscal stimulus were one of the reasons I was worried.) After reading their case for zero chance, I have to say that I am still worried. Verbally-intuitively, the case for a second dip still seems pretty overwhelming to me. I take comfort in the knowledge that I tend to have a pessimistic bias, and in the fact that sophisticated quantitative models are generally putting the odds of a second dip quite low. On the other hand, successfully forecasting recessions has not been a strong point of quantitative models.
Here is what I see as the case for and against a second dip. As you will see, I am more skeptical about the case against. Maybe someone can tell me what I have overlooked or how I am being too pessimistic.
The Case for a Second Dip
- The Fed’s policy of quantitative easing, which was temporarily buttressing demand, is over, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
- This fiscal stimulus, which was temporarily buttressing demand, has been largely exhausted and has likely reached its point of peak impact (even if additional fiscal measures are taken), so that its impact will be declining in the coming quarters, imparting a downward bias to growth.
- Pent-up demand from consumers (many of whom were worried about losing their jobs last year but no longer are) has been largely exhausted, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
- The process of inventory adjustment has run its course, and firms have been able to increase production again to maintain inventories at the new, lower level and to begin slightly increasing inventories in anticipation of a recovery. Significant increases in production are no longer necessary to maintain inventories, so that an upward bias that has been imparted to growth in recent quarters will no longer be present in future quarters.
- With the dollar relatively strong again and the pace of world recovery expected to slow, export growth, which had offered the possibility of a robust recovery, no longer seems to offer that possibility.
- Normally, the surge in productivity at the beginning of a recovery is followed by a surge in employment. They typical lag is about two quarters. Last year’s surge in productivity took place over the last three quarters of the year, which suggests that a surge in employment should have taken place beginning in the last quarter of last year and continuing through the current quarter. Aside from temporary census employment, the anticipated surge does not appear to be taking place. Meanwhile, productivity growth has settled back into the normal range, which dampens hope for a future surge in employment.
- The Bush tax cuts expire at the end of 2010, creating an incentive for high-income individuals (and their corporate agents) to shift income out of 2011 into 2010. To the extent that they are successful in doing so, and to the extent that the shifted income is associated with actual economic activity taking place during the period in which it is declared, we should expect a downward bias to growth between 2010 and 2011. (This point comes from a recent Wall Street Journal op-ed by Arthur Laffer, to which a colleague referred me. People who know my work well know that I have had my quarrels with Arthur Laffer in the past, but in this case, I don’t see any fundamental flaw in his argument.)
- Given all these negatives, there is no evidence of any positive stimulus to growth that would offset them. The financial panic of late 2008 subsided long ago, and the residual financial weakness is lifting very slowly, with no suggestion that the pace of improvement will accelerate, especially in light of potential fallout from financial difficulties in Europe. With capital ratios still an issue, the current regulatory environment is not conducive to rapid increases in bank lending.
The Case Against a Second Dip
- In the years since the Great Depression, there is no precedent for a long recession (longer than 8 months, in this case about 18 months) followed by a short recovery (shorter than 35 months). The two closest “double dip” examples (both with first dips lasting 8 months or less) are 1980 – when the second dip was essentially intentional on the part of the Fed – and 1960 – when the economy had already made nearly a full recovery by the time the new dip happened. On the other hand, double dips appear to have been fairly common in the years before the Great Depression, so the validity of this piece of evidence depends on the premise that something (the fixed gold standard?) fundamentally changed in the 1930’s and has not since reverted.
- Recessions seldom begin when the unemployment rate is already high. In particular, since the end of the Great Depression, we have not seen a recession begin with an unemployment rate greater than 7.5 percent. (Today it is 9.7 percent.) Having said that, though, I should note that the second dip of the Great Depression began with an unemployment rate of over 14 percent. (Presumably the reason this happened in the 1930’s is that fiscal and monetary policy were tightened, whereas in subsequent cycles, fiscal and monetary policy have generally been loosened when the unemployment rate remained very high. Unfortunately, in light of the first two points adduced in favor of a second dip, this contrast doesn’t bode well for the immediate future.)
- Recessions are normally preceded by stock market declines of greater severity than what we have seen recently. (Of course, if your concern is whether to own stock, the fact that the stock market has not yet had a large decline isn’t much of a comfort.)
- Credit spreads do not suggest a high risk of recession. (Again, if your concern is whether to own bonds, this is not much comfort. But perhaps the stock and bond markets should find each other’s lack of severe concern reassuring.)
- The price of oil has been reasonably stable, not exhibiting the sort of spike that has helped induce most of the post-WWII recessions. (However, since the second dip, if it happens, is likely to have deflationary characteristics, we need to be concerned that any lack of strength in commodities such as oil could be in anticipation of a second dip.)
- The yield curve (difference between long-term and short-term interest rates) is unusually steep. Recessions normally begin with a flat yield curve. Short-term interest rates normally fall during a recession, whereas a steep yield curve suggests rather that short-term rates are expected to rise. However, as Paul Krugman points out, this usual interpretation doesn’t apply now. If there is a second dip, short-term rates will not fall, because there is nowhere down for them to go. Under these circumstances, the steep yield curve likely only indicates the possibility of a rise in short-term rates (without the offsetting possibility of a fall), not the likelihood of a rise. In fact, it could be argued that the steep yield curve is reason to worry more about a second dip: in linear models, a false signal from the unusually steep yield curve could easily outweigh other indicators that are showing valid, but less intense, signs of trouble. (For example, the stock market hasn’t declined dramatically, but it has declined. Should we be worried? Ordinarily, with such a steep yield curve, the answer would be an unambiguous “no.” Today, we’re likely to hear that “no” from linear models, but it could well be based on a single indicator giving a flawed signal.)
It’s possible that the case for a second dip is basically right but that we still don’t technically get one. With normal productivity growth and population growth, we could have a severe slowdown, involving maybe one quarter of negative growth, or two quarters of very slightly negative growth, or three quarters of very slightly positive growth, and it might not qualify as a recession. Obviously, it would still suck.
What worries me particularly is that, even if the case for a second dip is completely wrong, the employment picture going forward is still dismal, and there is still a case for deflation. Am I wrong in understanding that this is standard textbook macroeconomics? There is a non-accelerating inflation rate of unemployment (NAIRU). When the actual unemployment rate is above the NAIRU, the inflation rate declines. The further the unemployment rate is above the NAIRU, the more quickly the inflation rate declines. The unemployment rate is currently 9.7% and is not expected to fall rapidly, even under optimistic scenarios. Recent estimates put the NAIRU at about 5%. The current core CPI inflation rate is about 1%. You do the math.
FOOTNOTE: Well, OK, technically you can’t do the math, since I didn’t give you a Phillips curve coefficient. From what I can tell, Phillips curve coefficients are all over the map these days, with some people arguing that the coefficient is zero as long as monetary policy is credible. (But is monetary policy really credible?) At the other end of the spectrum, coefficients with magnitude as high as 0.5 (implying a half percentage point decline in the inflation rate each year for every percentage point that the unemployment rate is above the NAIRU) seem to be well within the mainstream. I recommend against doing the math with that coefficient if you have a heart condition.
Disclosure: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.