Double-Dip Forecasts Did Not Do A Disservice By Changing Expectations

by: Tim Duy

Dean Baker admonishes those concerned about a double-dip:

...The economy looks to be growing in a range of 2-3 percent. This is roughly fast enough to keep even with the growth of the labor force. That implies that we are making zero progress in putting people back to work.

Unfortunately, because many economists misread the economy and raised the specter of a double-dip, this slow growth is likely to be seen as good. It isn't and the double-dippers have done the country a serious disservice by creating a set of incredibly low expectations against which economic performance is now being measured.

As I have previously stated, the economy was clearly not in recession in the third quarter, and therefore near-term data would certainly not be consistent with a recession. Indeed, this has been the case. If you expected the bottom to fall out of the economy in the fall, you have been disappointed.

Moreover, the primary reason to believe in a reasonably high probability of recession had little to do with the US data to begin with. To be sure, the overall low rates of growth in this "recovery" does imply that downward negative shocks will push us more easily into recession, and this suggests we may face an increase in recession scares in the years ahead. That said, the first half slowdown is really only a supporting character in the recession story. The lead character was and remains the European situation.

And despite the seemingly endless optimism on Wall Street that Europe will come to an agreement that forestalls a deeper crisis, the reality appears to be very different. My interpretation is the press reports suggest complete and total disarray among European government, as 17 economies all with different objective functions struggle to define the meaning of "Union." This is not stuff for the faint of heart. The differing objective functions and the subsequent need to make all parties happy by itself suggests that at best only a partial solution is at hand, and we are way beyond partial solutions. Moreover, beyond governmental agreement comes the issues of force feeding capital to the banks and the willingness of Greece's bondholders to accept a significantly higher haircut without creating a credit event. I kind of hate to be a pessimist, but good luck putting all that in place by next Wednesday.

Meanwhile, as Edward Harrison points out, while Wall Street may be buying what the EU is selling, European financiers see the writing on the wall. Italian yields are nearing 6%, effectively unwinding the efforts of the ECB to contain the crisis with their earlier bond-buying campaign. Moreover, yield spreads throughout Europe are blowing out. Calculated Risk was always found of saying "we are all subprime now." Well, increasingly it looks like all of the Eurozone is the periphery.

Finally, over at The Street Light, Kash reports Greece is most likely on their last austerity package:

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

Does this get better before it gets worse? History says no. Back to Edward Harrison:

It seems to me that we risk a true Armageddon scenario here from dithering.

A major credit event in Europe looks inevitable. Would a European meltdown endanger the US recovery? We are looking at two channels, trade and financial. I tend to discount the trade channel. As a general rule, I think the propagation of such shocks is too weak to alter the fundamental cyclical forces underlying the US economy. The potential for financial shocks, however, keeps me up at night - this is the key to the US recession story. There is a nontrivial chance that credit event in Europe triggers a credit event in the US. This following quote from Bloomberg only increases my unease:

“We have looked very carefully at bank exposures both to foreign sovereigns and to foreign banks,” Bernanke said. “The exposures of U.S. banks to the most troubled sovereigns --Portugal, Ireland and Greece -- is quite minimal. So the direct exposures there are not large.”

That sounds just a little too much like there is no housing bubble and the subprime crisis is "contained." When it comes to how financial events resonate throughout the US economy, it seems best to bet against Federal Reserve Chairman Ben Bernanke.

Because of the uncertainties surrounding the European crisis and whether or not it induces a regime change in the US economy, forecasters lack conviction about the recession calls, with most circling around 50-50. At the same time, however, I don't see that the competing forecast could in anyway be called optimistic. Optimistic relative to recession, but the baseline forecast remains that of an economy still struggling along in the 2-3% range - a range no one thinks is acceptable given the current high levels of unemployment.

Finally, the forecasts of a double-dip did not do a disservice by changing expectations, as Baker suggests. In fact, I think clearly the opposite occurred. The concerns about the double-dip prodded the Federal Reserve to step up their stimulus efforts, with possibly more on the way. Ultimately, the Federal Reserve was pushed to go where it should have been in the first place.

P.S. I think that we are sufficiently past the last recession that the next recession stands on its own. The term "double-dip" is not really accurate.