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It could have been a lot worse

October 22nd, 2008 · No Comments

Some people seem to think we’re on the brink of a 1930s style depression. It ain’t going to happen. The policy response (after considerable dithering) has been much better this time around. Now, having said that, a recession, and a pretty nasty one, seems almost unavoidable. The good news is that it’s mostly priced in already.

The U.S. Recession Will Be Painful – But it Could’ve Been Lots Worse
By Martin Hutchinson Contributing Editor Money Morning

  • The U.S. economy is entering a recession. With each day that passes and each indicator we see, that eventuality becomes more and more clear.
  • Even so, we can take some real comfort in knowing that we’re likely going to avoid the “bottomless pit” of a Great Depression II. A substantial recession with accompanying inflation – roughly along the lines of the downturns of 1974 and 1980-82 – seems the most likely scenario we face.
  • The last two U.S. recessions – the 1990-91 downturn touched off by Saddam Hussein’s invasion of Kuwait and the subsequent recession in 2001 – were both short and shallow, and perhaps even unnaturally so. Gross domestic product (GDP) declined by about 1.5%, peak-to-trough, in the first case, and a mere 0.5% in the second.
  • In 1990-91, the tax cuts and other structural changes made by President Ronald W. Reagan had increased the trend growth rate of the U.S. economy, so only the artificial drag of the savings-and-loan crisis brought a modest recession. In 2001, the U.S. Federal Reserve was expanding the money supply so rapidly, and dropping interest rates so far below the level of inflation, that what might have been a substantial downturn after the 1996-2000 stock market bubble was turned into renewed recovery led by the housing sector.
  • The Portrait of a Downturn
  • Thus, our experience of the last two decades, when recessions have been both shallow and short-lived, is not necessarily what we should expect going forward.
  • This time around, it is fairly clear the recession will be deeper than in 2001, and perhaps even worse than its 1990-91 counterpart. Retail sales were down 1.2% in nominal terms in September and industrial production was down 2.6%, while unemployment has already risen from 5% to 6%, with payrolls dropping more than 600,000 since the start of the year.  That suggests that an overall decline in output of considerably more than 1.0% to 1.5% is highly likely.
  • At the other extreme, and very thankfully indeed, we are highly unlikely to see The Great Depression – The Sequel. Creating the first Great Depression required a horrific stock-market crash, followed by several major policy miscues. Key among them:
  • * A huge increase in tariffs (The Smoot-Hawley Tariff Act of 1930) at a time when world trade was already in a fragile state, and trade barriers were much higher than they had been before 1914.
  • * A 30% decrease in the money supply caused by bank failures, which made prices drop 20%, made real interest rates correspondingly high and was a major cause of real GDP dropping 25%.
  • * A major tax increase at the bottom of a deep recession, taking the top marginal rate of income tax from 25% to 63%.
  • This time around, we have already bailed out the banking system, are increasing the money supply at a rapid rate, and are fairly unlikely to enact a major tax increase in the trough of a recession. And even if protectionism revives, we are unlikely to see a re-run of Smoot-Hawley (in any case, world trade remains very robust, indeed).
  • All these differences are protections against Great Depression II, and they should be sufficient. That’s not to say we aren’t still looking at a nasty inflation problem, which is a separate question.
  • It’s High, It’s Deep – and It’s Gone
  • To figure out how deep the recession might be, look at a few factors in the U.S. economy that have changed or need to change. The housing decline has wiped out about $5 trillion of the nation’s wealth, and the stock market fall has eradicated an additional $8 trillion; taking a reasonably pessimistic view of both would suggest a total eventual wealth wipeout of about $20 trillion.
  • Past studies have suggested that there is a “negative wealth effect” in a market crash, with an annual consumption decline equal to about 3% to 4% of the wealth wiped out: In other words, for each $100 a consumer loses, they will reduce their outlays by $3 to $4. That translates into a consumption drop of about $600 billion to $800 billion, which equates to about 4% to 5% of our current GDP.
  • To look at this another way, the U.S. payments deficit is now around $750 billion per annum, or 5% of GDP, and will need to be eliminated – or nearly so – since foreigners won’t want to go on pouring that amount of money into the U.S. market. That also suggests a re-balancing of U.S. trade by about 5% of GDP. This rebalancing will probably come partly from decreased consumption, which itself will reduce imports, and partly from a decline in the value of the dollar, which will increase exports.
  • Finally, the abysmal U.S. savings rate is currently around zero, or maybe 1% of GDP, and has historically been around 5% to 6% of GDP. This also suggests a switch from consumption into saving of about 5% of GDP, although that’s realistically probably a very long-term change.
  • Those factors all tend to suggest a GDP decline of around 4% to 5%, top to bottom. That would be a little more than the recession of 1974, or the “double-dip” recession of 1980-82 – each of which equated to about 3.5% of GDP. However, as occurred in 1980-82, the anticipated decline is unlikely to happen in one leg, but will probably take a “double-dip” form. That’s because interest rates are currently very low, far below the rate of inflation. Hence, inflation will probably accelerate, alleviating the housing problem (because incomes will rise approximately in line with prices, making housing more affordable).
  • Once home prices have bottomed out, and the housing market has stabilized, banks will resume lending more aggressively and the economy will move into a full-fledged recovery mode.
  • Where Are You Paul Volcker?
  • At that point, since interest rates will have been far below inflation for several years, inflation will have accelerated, and will be accelerating harder. Hence, a change in U.S. Federal Reserve policy will be needed – probably one that pushes short-term interest rates far above the rate of inflation, as then-Fed Chairman Paul A. Volcker did from 1979 to 1982, a painful-but-effective assault on inflation, that sent pricing pressures packing for two decades.
  • That will inevitably cause a second “dip” in the economy, but by this stage the housing and financial sectors will have stabilized, and the second “dip” will be focused on corporate profits and the “real” economy. Profits’ share of GDP, which has been at an all-time high recently, will decline to more normal levels.
  • That is an unpleasant picture. It is bad news for stock prices and it may take five years to work through, albeit with a likely mild “bounce” in the middle.
  • But it could have been much worse. It’s nowhere near as bad as the nightmarish Great Depression, or the long, drawn-out and relentless rolling Japanese recession of 1990 to 2003, which led to that country’s “Lost Decade.”
  • And for that we must be grateful.

Tags: Credit Crisis