Curb your [ economic recovery ] enthusiasm
* Apr 16th 2010, 12:48 by G.I. | WASHINGTON
ECONOMIC optimism fills the air, like the petals of the cherry blossoms
around the tidal basin. On its front page Thursday the Wall Street Journal
declares, “Evidence mounts of strong recovery.” USA Today blares, “New jobs
fan rising economic optimism.” Newsweek’s cover proclaims America “The
Comeback Country” and Bloomberg BusinessWeek tells us, “Obamanomics is
working better than you think.”
Curb your enthusiasm. Yes, the economy is recovering, as everyone save the
nihilists expected. However, the debate ought to be about the strength, not
the fact, of the recovery. At the risk of gross oversimplification, the
debate is this: do we follow the strong recovery model (the “V”) which holds
that deep recessions are followed by strong recoveries, or the weak
recovery model (the “U”) that holds that recessions caused by financial crises
are followed by weak recoveries? I have long been in the latter camp. In
fact, I describe my forecast as “reverse square root”, sort of a cross
between a V and U (credit to George Soros for the term): an early cyclical
rebound followed by muted growth. I’m still there.
Wait a minute, didn’t The Economist lead this cheerleading with a cover
proclaiming, “Hope at last”? Well yes, but our hope concerns the composition
of growth, not its magnitude. We think (or hope) that in coming years,
exports and investment will lead, consumption and housing will lag, saving
will rise and the current account deficit will shrink. That can be true
whether growth is weak or strong, although it would be infinitely easier were
growth strong. (In fairness, most other news organisations have not equated
these green shoots with a V.)
I find it interesting that amidst all this optimism and the stock market’s
solid rally, the Federal Reserve has not lifted its own economic forecasts.
Don Kohn, the vice-chairman, said last week that his outlook hasn’t
changed since October; things have more or less progressed as he expected.
Kohn
also subscribes to the post-crisis recovery model.
Now, to the evidence. So far, the magnitude of growth does not validate the
V. GDP fell more during the 2007-2009 recession than in either 1973-75 or
1981-82 and has recovered less. Assuming GDP grew 3% (annualised) in the
first quarter, which is the consensus, then it will be up 2.8% (not
annualised) in the nine months since the recession ended, compared to 3.8%
after
1975 and 5.6% after 1982. Yes, employment is finally rising, but as The
Economist notes, its performance is far worse than after other recessions.
Second, the composition of growth looks unsustainable. A disproportionate
amount so far has come from inventories which are not a sustainable source
of demand. Relative to expectations, final demand is a wash: consumption has
been stronger but housing has been weaker. Our special report argued
consumer spending cannot lead the recovery because wealth has been devastated
and credit is tight. Contrary to that thesis, consumption has outgrown income
in the past quarter, saving has declined, and the trade deficit has
widened, though only a bit.
Can that be sustained? Yes, if credit were flowing easily. V shaped
recoveries derive their shape from the Federal Reserve: when it tightens, it
suppresses interest-sensitive demand. When it eases, it unleashes pent up
demand. But after a financial crisis a traumatised financial system stops the
benefits of easy monetary policy from reaching households. Banks have
tightened their underwriting standards, and even if they hadn’t, many
households
wouldn’t qualify with their homes worth less than their mortgages. Meanwhile,
the shadow banking system of securitised loans, though coming back to
life, remains (ahem) a shadow of its former self. Bank credit may have stopped
shrinking but it has collapsed by more than it seems. Economies can grow
while credit contracts but American and international experience says they don
’t grow rapidly.
Banks are healthier than we had a right to expect a year ago for which Tim
Geithner deserves credit. But the new narrative about Geithner—that he
braved political peril to pursue the most economically effective solution to
the crisis—is too kind. That would have meant spending hundreds of billions
of public dollars buying up, and extinguishing, bad mortgages. He did not.
(I don’t really blame him—the politics were lethal.) Those mortgages still
clog the financial system and will continue to until banks have earned
enough to write them off without endangering their capital.
An important reason for caution is that much of the recovery we’ve seen so
far is down to fiscal stimulus. It probably accounted for half of the
estimated 3% growth in the first quarter. Its contribution will turn negative
by
the third quarter. We need a virtuous cycle of incomes and spending
underway by then, which means stronger job creation than we’ve seen so far. I
still think it will happen. The economy is highly unlikely to dip back into
recession; 3% growth seems a safe bet. But I don’t yet see the makings of the
5%-plus growth that would characterize a V, though I’d love to be wrong.
The underpinnings of growth are fragile enough that monetary policy should
still err on the side of ease. The Federal Reserve can take its time about
tightening, either conventionally or by selling assets, since core
inflation is running well below its 2% target. For fiscal policy, the equation
is
more complicated. Were market conditions no object, it too should err on the
side of ease. But deficits and debts are on a dangerous trajectory. With
downside risks to the economy shrinking, Obama can afford to let stimulus
expire, and rely on a patient Fed to keep the recovery alive. But he should
remain alert to the risk of a stumble in the third quarter—in which case,
all bets are off
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