Debating the Business Cycle: Alternatives, Risks & Catastrophes
Over the weekend a friend asked me what the result of the stimulus package was likely to be and
how important it was. While we've asked and answered that question before we ginned up a little graphic to make things a little clearer. And also to make clear what the alternatives are likely to be, how it relates to history and why the "over-sanguinity", coining a word, of most market and economic commentators is likely to be severely mis-placed. Below the line you'll find an earlier chart that looks back to the investment bust and the consequences for the cycle. And, as it happens, three respected and respectable commentators just popped up this morning with dead on observations. All of which we suggest you skim. But let's start with this chart which lays out things the way we see them.
As the legend explains it the black line is the base case. Now we've deliberately left off the vertical numbers because if base line growth is, say, 2.5% then the whole chart rotates left so the trend line points up. That gets back to the basic point that a growth recession where GDP growth is < 1% will be as painful as negative growth.
UPDATE: Barry Ritholz over at TheBigPicture has a nice little riff on what is a recession, where we might be at and some real world stories. This kinda puts all this abstract chartsmanship in context.
Understanding What Recessions Are One of the misunderstandings about recessions is what actually happens in the real world. A recession is where economic growth stops, and you are left with flat to contracting sales. Note that economic activity does not grind to a halt -- the year-over-year growth rate merely slips into the negative. This is often misstated, in some variation of "Gee, how it can it be a recession -- I was out shopping and the stores were pretty crowded." Whenever you see that, the speaker is either technically misunderstanding what a recession is -- or alternatively, is painfully long and hoping for the best. Of course, Growth may falter, not total economic activity. With the $13 trillion US economy, economic activity certainly won't fall to zero dollars.
The problem is that the base case - what one might expect if we were in normal circumstances isn't the one that scares the Fed nor people like Feldstein, Summers or Stiglitze, or Roubini for that matter (notice we're not citing Wall St's finest here as they tend to let the fact that there dog is in the hunt distort their commentaries. That said, Hartzius (G-S) Roach (Morgan-Stanley) and Merrill's economist are pretty much in agreement and are "undistorted" voices here). The case everybody is scared to death about is the red line where the Housing and Credit bubbles cause years long malaise. Whatever we need to do to avoid that is, in our opinion entirely justified. But even if the Fed, the stimulus package and the next packages that the new president will need to put in work cycles are cycles. In other words the best outcome is the yellow line. Unfortunately none of this appears to have crossed the Chinese firewalls from one side of the investment community to the other. As we've ranted on about several time earnings and recession outlooks are very optimistic and are represented by the shallow drop and quick re-acceleration of the pink line (& no the color is not purely a mechanical choice).
While disingenousness is part of the problem the real breakdown is likely in people's views of the world. The green line shows a "normal" business-cycle pattern based on historical experience, that is what things might look like if the '90s and the century-to-date hadn't been so different from prior post-WW2 experiences. We go into that more below but the reason is that the Telecomm/Internet boom/bust was an investment-driven instead of consumer-led cycle. Now we've been flapping away at that notion for a while AND noticed that the meme is in much wider circulation. The problem is that the implications aren't factored into people's thinking - they're still, in their hindbrains, judging now by history, which is where they got imprinted like a baby duck.
So let's go back a little and understand how & why things were different and what those consequences
are. The solid line shows a normal cycle while the dotted one shows a typical historical boom and bust (depression) cycle. The late '90s saw huge over-investment in capital, particularly technology, which also pushed up hiring. Normally when investment is that much in excess it's followed by a much longer and deeper downturn as the excesses are worked off, savings build back up, and new replacement investment begins to re-start the feedback loops. We've had several major downturns of that sort and Japan has yet to recover from its'. The consequences are severe and long-lasting - it took the largest and worst war in history to dig us out last time. What actually happened is shown by the dotted line. While GDP did fall it did't go as far though Investment went off a cliff. We held up Consumption thru a combination of low interest rates and fiscal stimulus which were the proximate causes of the Housing and Credit bubbles and our current strucural risks. But this "recovery" never reached a stage of organic growth where new, net job creation led to increased demand which in turn increases investment and tat generates more jobs. Instead we had the worse job creation recovery on record post-war; and net net we're still almost 3 million jobs in the hole by my estimates.
READINGS
It's too early to be bullish If you listen to some prominent market professionals, you might think the worst is over. But the credit/housing bubble is a far bigger mess than the tech-stock bust. The Sanguinity Chronicles. That's how I might title this week's column to capture the changing perspective of three once-wary market observers. I respect their views and include them here to update the bull/bear debate I began last week. To reiterate my view: Those who are really bullish, as opposed to being open to a potential bullish resolution, do not completely understand the ramifications of the credit/housing bubble and what the unwinding means. Someone who does grasp the ramifications and remains quite negative is GMO's Jeremy Grantham: "People think the Federal Reserve can stop a bear market because they can throw money at it and lower interest rates. It is even more certain we can collectively stop a bear market if some fiscal stimulus is thrown in. To which I say, 'Oh, you mean like 2000 and 2002?' -- when they threw what I call the greatest stimulus in American history, an unparalleled series of interest-rate cuts, cumulating in two, almost three, years of negative real returns, real interest rates coupled with a really substantial tax cut, which would never have happened without 9/11. "The combination would have gotten the dead to walk, and it stopped the bear market eventually. But the Standard & Poor's 500 ($INX) was down 50%, and the Nasdaq ($COMPX) -- which was all anyone talked about back then -- went down 78%. And a puny five to six years later, people are saying there is not going to be a bear market because the Fed is going to lower rates and because the government is going to have a stimulus package. But we have just been there, done that, and we had a nice bear market." (Click here to read the interview.) To which I would just add a point that I have made regularly regarding the difference between the two bubbles: We now have bad debts. The lender has a debt he can't quite collect on. The borrower has a debt he can't service. That is a much different proposition than what we dealt with in the wake of the stock bubble.
This Credit Crisis Has a Long Way to Run This is much more global than, say, the savings-and-loan crisis was. The world is obviously much more globalized than at any time since the late 19th century and much more interrelated in almost every way, certainly financially. To have the leading economy and the reserve currency having a major-league credit crisis would by itself make it more important than earlier ones. Secondly, this occurred at a time of what I believe is the first global bubble in pretty well all asset prices, so there is a much greater degree of broad-based vulnerability. Then it is a question of degree, and how carried away the sloppy lending was: It was very carried away. Not just in the design of needlessly complicated instruments, but in the enthusiasm -- recklessness one might say -- with which they were sold.
America’s recession will be hard to shift Monetary policy affects the economy with long and variable lags. This much we know. How long depends on the state of the economy in question. In 2001, the US got away with an unusually short recession helped by aggressive interest rate cuts and an expansionary fiscal policy. But in Japan in the early 1990s, and in Germany in the early part of this decade, it took ages for low interest rates to help the real economy. One of the reasons was that those recessions were aggravated by crises in the financial sector itself. I fear that the US recession of 2008 will be similar in quality – though not necessarily in length and depth – to those in Japan and Germany, rather than to the US recession in 2001. Interest rate cuts work their way through to the real economy by a number of transmission channels. During the 2001 recession in the US, the most important was housing credit. The rate cuts came at a time when the housing market was already booming. They turned the boom into a super-boom. Inflationary expectations were low. People expected interest rates to remain low. It was a great moment to take on extra debt, and this was precisely what Americans did. The current US downturn could not be more different. House prices are falling, and have further to fall before reaching a more sustainable level (in terms of the price-to-rent ratios as well as several other measures). It would therefore be unwise, to say the least, for policymakers to rely on monetary policy alone. By far the best policy response – though clearly limited in scope – is a well-targeted fiscal policy stimulus, a point recently made by Lawrence Summers, the former US Treasury secretary, in his Financial Times column. The best stimulus package would be one that could be agreed today, enacted tomorrow, targeted specifically at subprime families, and was only temporary. Back in the real world, where politicians run fiscal policy, this is obviously not going to happen.
PRIOR POSTS
Stage II Denial: Recession Downside Risks and Fracture Lines
Cramer's Comeuppance vs Pump Priming Realities
Weigh the World Works: Understanding the Business Cycle
WtW Part Deux: Patterns, Cycles & Indicators