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.â€
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.â€
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 “Vâ€) which holds that deep recessions are
followed by strong recoveries, or the weak recovery model (the “Uâ€)
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 rootâ€, 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
