Cyclical boom, structural drag (i.e. not an easy way out)

Posted by Luca Noto on 3 August 2009

We are experiencing the worst recession of post war era: real GDP plunged in developed economies as a consequence of the deepening of credit crunch and the collapsing of global trade. Headwinds came from both cyclical and structural forces. Now that even the IMF is starting to upgrade world economic growth, it is time to guess about the recovery.
Previous recessions provide abundant evidence that the deeper the recession, the stronger the bounce: USA economic data show that previous recessions led to a -1.9% drop of real GDP followed by 2 years of 5.0% recovery, on average. A curious statistic tell us that for all of previous post WWII episods of contraction, it took less than one year for the economy to come back to previous levels. Given the extraordinary measures put in place (wall of money coming from central banks and the record steepeness of yield curves, fiscal deficits at record levels) anyone of the economic community should be tempted to forecast a booming economy going forward.
This time could be different. Unprecedented forces represent headwinds for a global recovery: a record destruction of wealth, record layoffs during a recession in US, and excessive debt over GDP in anglosaxon economies guarantee a long haul of deleveraging in coming years. Moreover, after the Lehman failure and the full materialisation of credit crunch, global trade collapsed at rates of change never seen. During recessions, cyclicals tend to underperform. For example, personal consumption expenditure is less affected by cyclical factor (because of households smoothing) anchoring real GDP growth during contractions; viceversa, capital expenditure, exports and inventories tend to overeact, exhibiting a more pronounced variability given the nature of the decisions behind them.
Actually, recession evolved quite differently this time. In USA, housing wealth effect, foreclosures and labour layoffs caused a contraction of real consumption; capex dropped significantly only after international trade shut down. Employment adjustment started earlier than usual and was more pronounced in services sectors (first time since 1950). Lack of domestic demand resulted in an ample excess capacity weighting on new investments, making deflation risk another source of uncertainty.
Two factors are poised to exploit the turning point: exports and inventories. On inventories, most of the companies have already stocks aligned with demand and a marginal increase in final consumption will support a huge contribution from inventories. A record destocking in Q2 (around $150bn) could easily be reversed, adding several points to next quarters reading of real GDP.
Futhermore, international flows starts to re-emerge, an evidence from Japanese and Chinese exports. However, the collapse of global trade was not fully explained by income elasticities (Demystifying the collapse in trade, Caroline Freund, VoxEu 3 July 2009). Structural changes in transactional credit flows and financial re-intermediation could dampen the return to previous levels in the foreseeable future.
Separating economic news flows into structural and cyclical is crucial to assess the scenario for next few years. To assess current recovery in real time, it could be useful to draw a roadmap: 1) do not extrapolate positive indication of inventories and exports unless domestic private demand shows genuine sign of strengh; 2) watch labor market indicators: they should improve “before” domestic consumption stabilise; 3) don’t get too excited by recent home price development, a second leg is possible; 4) do not overestimate expansionary fiscal policy, some will pay for the deficit sooner rather than later; and finally 5) monetary policy mistakes are guaranteed by definition.
Confidence is the key Mr President; but it seems too early for a “new deal” or a new productivity miracle. The healing process has just started and it could take years to find a new theme economically sensitive. Hence, let China play the role of leading economy, at least for a while.

Luca Noto
Senior Economist at Prima Sgr