Path of Economic recovery: Future Outlook in the light of past

Tuesday, December 8, 2009 , Posted by Team Niveshak at Tuesday, December 08, 2009

Anirban Das
Shibasis Biswas
IIM Ahmedabad

When it comes to grading the current state of the world economy, most professors will brandish a C- (or whatever is the lowest grade in your B School). But the letters presently hogging the limelight in this space are – U, V, L and W, referring to the expected speed and shape of the economic recovery.

The Shapes

An economy in deep recession that drags on for a long period of stagnation, that is what an L shaped recovery signify. Chilling as it is, it is not unprecedented. The Japanese experience in the 90s provides such an example (Figure 1).
The shape we are more used to, and are certainly
hoping for is a V, with the upturn being as sharp as the downturn. Most recessions since 1940 have taken this shape, but with the housing and credit markets devastated, there is a certain sense of apprehension about the pace of recovery.

The data provided by a USA Today survey shows that 37% of the consumers actually expect the economy to take a U shaped path, making a longer arc of bottoming before recovering. This view is particularly important given the lack of similarity of present crisis with earlier downturns. That principally stems from the outsized role the financial system plays in today’s world economy, compared to the underlying sectors of the previous recessions. While Green Shoots are in vogue today, with most of the economies coming out of recession in 3Q, the concerns are still there about the sustainability of the upturn achieved on the back of unprecedented government stimulus.

The concerns in fact bring out the possibility of a completely new shape further down the alphabet – a W shaped recovery. Economists in this league believe that the recovery will lose steam in near term condemning the economy to another sharp downturn before finally picking up for good. Their logic lies in the means used to achieve the recovery – the Fed along with other central banks have printed money and kept interest rates to record low levels to somehow raise the consumer sentiment. The negative effects of these will most probably be manifested in inflationary pressure over-growing the upturn, and regulators being forced to fight it hard, as envisaged by JHU economist Steve Hanke. The resulting prospect of renewed banking losses and increased tax burden is highly likely to produce another dip.

The Economy in 2009 – Where do we Stand

Worst recession since the Great Depressions – GLOBALLY

The key aspect of the present crisis we are in has been the widespread nature of it. The worldwide linkage of the financial system and trade meant that the collapse of financial systems in the USA prompted a synchronized collapse in trading activities across the world. The very reason economists like Simon Johnson, former IMF research director, feels that we are into
a recession that is fundamentally different from previous ones. The United States in 1980s and Japan in 1990s were able to recover because demand from the other parts of the world allowed them to build recoveries based on exports. The pervasive nature of the present recession meant
the whole world was stuck in a deadlock, with everyone losing. Consumer confidence reached its lowest ebb; businesses were squeezed from both ends as credits dried out completely. Job losses reached unprecedented levels (estimated at 7.2 million by the latest Bloomberg data), stock markets crashed world over and the dollar climbed as investors withdrew money from markets to cover their losses and consumer savings rate increased to 5.2% in second quarter on 2009 from 1% before the crash (Bloomberg). Lehman became history, AIG, Citi and GM had to be bailed out by government interventions. In effect, the prides of the world’s largest economy came down crashing. All the talks of decoupling came out to be effective in theory only as the world’s biggest economies entered into recession one by one.

Government Actions

Unprecedented events call for unprecedented actions.
After initial stubbornness (by lettingLehman fail), the
proponents of Efficient Market theory had to come rush out to curb the mayhem that followed. Interest rates were brought down to unforeseen levels by the central banks, with the Fed leading the way with near zero rates (Figure 2). Bail outs became a common word as governments worldwide came out with massive stimulus packages to resurrect the economy (Exhibit 1). An end was not easy to come nevertheless, with all major economies contracting or at least slowing down for multiple quarters.




Green Shoots Emerge – Emerging Economies Lead the Way

They did not come easy, but signs of bottoming out slowly started to emerge in the second quarter of 2009 as the stimulus reached some depth. For the first time since June 2007, economic outlook for the OECD countries were revised upwards compared to the previous issue in the June 2009 issue of the OECD Outlook (OECD). The arrest in the contraction was caused by inventory adjustments by businesses, recovery in non-OECD economies as well as the effect of the stimulus programs (OECD). The biggest effects were seen in the stock markets, with the S&P gaining as much as 47% from its March nadir. Dean Maki, Chief US Economist of Barclays Capital opines that while consumer savings rate will remain high, the excess return from investments should see at least moderate growth in spending. The signs are indeed there now, with Germany, Japan and the USA coming out of the recession in 3rd quarter 2009 (Bloomberg).

The other major part of the recovery story has been the performance of the emerging economies. The findings of the third Global Economic Conditions Survey by the ACCA (a Global body of professional accountants) note significant regional variances as Asia-Pacific, Africa and to some extent Central and Eastern Europe reported higher levels of business confidence and optimism compared to Western Europe and the Americas. The Asia Pacific region was in positive territory in all the major indices measured by the survey, strengthening the growing belief that these economies will pull the world out of the slump. Indeed, the economic data coming out of the new economies like China and India (Exhibit 2) have given rise to renewed hopes of a smooth recovery.

Back to Shapes of Recovery

The question therefore is no more about whether recovery has started; almost every economist agrees that it has. What is not certain though is the pace of the recovery, leading to the argument regarding recovery curve shapes as we defined before. Economists like Michael Mussa (former Research Director at the IMF) argue for the case of a V Shaped curve whereas their counterparts like Simon Johnson are much more pessimistic, predicting the gloomy possibility of a U, W or even a L shaped up-move.

The Optimists

The sources of sustainability are two-fold according to them –

People’s confidence in government programs will translate into sustained spending as they believe that government interventions will rectify the market inefficiencies

Analysis of previous recessions shows a clear trend of strong downturns followed by equally strong upturn. Economists like Mussa believe that slower recoveries result from lack of government intervention, which certainly has not been the case here

The growth in the USA is likely to come from –

Producers moving to cover their largely depleted inventories in the wake of the double effect of huge inventory cuts and government stimulus programs (e.g. Cash for Clunkers) that raised sales suddenly

Business investment in software and equipments have not risen in the up-move of the previous quarter, staying at a level of 22% cost cut from pre-recession levels.
These historically lag the upturns by a quarter, and is likely to take part in the recovery in
forthcoming quarters

Housing prices have bottomed out in all probability. With increased facilities for house purchase (low mortgage rates for qualified buyers and low prices) and increased confidence that the worst is over, the housing market is likely to recover one-third of the lost ground since its 2005 peak

The growth in exports is likely to remain modest, but past experiences (the Regan recovery of 1982-84) indicate that it is not expected to decline significantly during a recovery phase

The growth drivers for the rest of the world are given below:




The Naysayers

Primary arguments of this group remain that –

The current slow-down is different from any previous recessions due to its global nature, raising the possibility of a global demand deadlock. The root cause of the recession being financial systems, the linkage is too strong for any sort of decoupling to work

The psychological effect of losing one’s place to stay is likely to haunt the consumer
sentiment for years to come. Even when the prospects look up, spending is not expected to rise to levels from where it can sustain the government spending induced recovery

Indeed, supporting evidence exists in quite a few areas –

The US fiscal deficit has risen to a historically unforeseen level at $1.75 trillion (Fiscal).
Government’s ability to push in further stimulus is limited

The unemployment claims have not followed the upsurge of the last few months. New unemployment claims have fluctuated to some extent over the last few weeks, but have stayed at historically high levels (Figure 3)













Trade is still contracting at double dig
it rates in OECD countries (Figure 4)











Concerns about the banking system remain (as demonstrated by the high bank Credit Default Swap rates) in spite of the recent improvements in financial system (Figure 5)

Valuations in stock markets seem to overgrow the up turn, raising clouds of another bubble in the making

Conclusion – What is in Store

The breadth and depth of the present global contraction makes it a unique situation where each and every step by the major participants can assume significant proportion. There is a possibility of underestimating the growth in consumer sentiments, as has been the case with previous recessions. At the same time, the downside risk of overestimating the confidence level is also significant. On the positive side, US GDP rose at 3.5% in Q3, bringing in cheers from all over the globe. But further scrutiny reveals that 1.66% of growth was from Cash for Clunkers (one time effect), while inflationary estimate was 0.8 – 1.5% leaving us with a more realistic estimate of around 1% growth, even in time of unprecedented government boost(Reuters). While predicting a W shaped recovery might seem too pessimistic, emergence of a new world order where growth rates are steady but moderate is a much more probable. For developed countries, this rate may range from 1.5-2% as compared to the 3-3.5% during previous boom times.

While we all would like to see a V shaped recovery, the possibility of that is by no means certain. Role of governments and regulators assume primary importance here, as they need to balance the critical requirements of growth and inflation. A key decision will be the time to withdraw from the stimulus programs, as global markets still seem to be short of reaching the self-sustaining confidence level. Already though, the Australian and Norwegian central banks have raised rates indicating exit fromthe stimulus program. Sooner or later, other governments will have to follow suit, but the timing and manner of those phase outs will determine the course of recovery. Cut-backs must be gradual, and not of sudden nature. The path to recovery is still fraught with dangers; we must tread with extreme caution as the world possibly can’t sustain a recurrence of the worst recession since the great depressions








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