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The Shape of the Coming Recovery

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The Shape of the Coming Recovery The Shape of the Coming Recovery Mark Zandi July 9, 2009 he Great Recession continues. Given these prospects, a heated debate will resume spending more aggressively. After 18 months of economic has broken out over the strength of the Businesses may also have slashed too T contraction, 6.5 million jobs have coming recovery, with the back-and-forth deeply and, once confidence is restored, been lost, and the unemployment rate is simplifying into which letter of the alphabet will ramp up investment and hiring. fast approaching double digits. Many with best describes its shape. Pessimists dismiss this possibility, jobs are seeing their hours cut—the length Optimists argue for a V-shaped arguing instead for a W-shaped or double- of the average workweek fell to a record recovery, with a vigorous economic dip business cycle, with the economy low in June—and are taking cuts in pay as revival beginning soon. History is on their sliding back into recession after a brief overall wage growth stalls. Balance sheets side. The one and only regularity of past recovery, or an L-shaped cycle in which have also been hit hard: Some $15 trillion business cycles is that severe downturns the recession is followed by measurably in household wealth has evaporated, the have been followed by strong recoveries, weaker growth for an extended period. federal government has run up deficits and shallow downturns by shallow A W-shaped cycle seems more likely approaching $1.5 trillion, and many state recoveries.2 The 2001 recession was the if policymakers misstep. The last time and local governments have borrowed mildest since World War II—real GDP the economy suffered a double-dip was heavily to fill gaping budget holes. never posted two consecutive declining in the early 1980s, when policymakers Despite the grim statistics, quarters—and the subsequent recovery attempted to rein in double-digit inflation economic conditions are slowly firming. was exceptionally tepid (see Chart 1). In with credit controls and extraordinarily Households are cautious, but they are contrast, the recession in 1957-58 was tight money.4 This time around, policy no longer panicked. Spending and home especially severe, at least as measured by mistakes seem more likely to involve efforts sales, which were in free fall through the decline in GDP, and the subsequent to quell the mounting foreclosure crisis, last Christmas, have since stabilized. recovery was robust.3 as the administration’s current plan to Businesses continue to cut costs, but For a V-shaped recovery to follow facilitate mortgage loan refinancings and the cutting is not nearly as draconian as in the wake of the current Great modifications has gotten off to a painfully it was just a few months ago. Overseas Recession, there must be a quick revival slow start. Whether the recovery gains customers are ordering again, providing in confidence. Sentiment usually reflects traction and evolves into a self-sustaining some lift to exports. Investors are economic conditions; it does not drive expansion or descends back into recession calmer as the financial crisis has abated them. But the severity of this downturn will likely depend on whether policymakers meaningfully in the wake of the Fed’s was due in part to a psychological shock: find the political will to maintain or unprecedented efforts, the Troubled Asset Consumers, businesses and investors lost increase support to the economy. Relief Program, and regulators’ stress tests faith in the economy and panicked. It is A darker L-shaped scenario could on the nation’s largest banks. thus conceivable that some households resemble the Japanese experience of the With fiscal stimulus providing its pared their spending more than they 1990s, following their banking debacle. maximum economic benefit in the next few needed or wanted to, and thus they The current financial crisis seems to months, real GDP growth should turn from have passed its worst point, but financial negative to positive in the current quarter. institutions still hold hundreds of billions 2 This is known as the Zarnowitz slingshot; named for The arbiters of the national business cycle at Chicago academic Victor Zarnowitz, who observed this of dollars in toxic assets, and credit the National Bureau of Economic Research relationship. Zarnowitz did much to advance the study of markets remain troubled. Moreover, will thus eventually proclaim that this business cycles and was a long-standing member of the unlike the Japanese, who finance their business cycle dating committee of the National Bureau of 1 recession ended sometime this summer. Economic Research until his recent death. large budget deficits with their own 3 The horizontal axis in Chart 1 measures the peak-to- saving, U.S. budget deficits are largely trough percent decline in real GDP in each recession since 1950; the vertical axis shows the percent increase in real 1 The business cycle dating committee at the NBER will GDP in the first two years of the subsequent recovery. The likely not make this determination until sometime next regression line shows the significance of the relationship 4 The policy steps that led to the early 1980s double-dip year, as it waits to get a complete set of economic data. The between the severity of recessions and the strength of the were arguably intentional, designed to break that period’s committee prizes accuracy above timeliness. subsequent recovery. runaway inflation. Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / June 2009 15 Chart 1: Not Your Father's or Grandfather's Business Cycle housing inventory positive note with a consideration of the % change in real GDP and spent-up V-shaped cycle, which accounts for the vehicle demand. remaining 20% of the distribution of 15 1957-58 Problems plaguing possible economic outcomes.6 1970 the banking system U-shaped cycle. In the baseline or 1960-61 1980-82 and credit markets most likely U-shaped scenario, the Great 10 will also take Recession ends in the next few months Average 1953-54 1974-75 time to resolve, (see Table 1). It will be remembered as the 1990-91 recession ensuring that the longest, most severe and broadest-based Current business 7 cycle credit crunch downturn since the Great Depression. 5 2001 will lift slowly. Employment is expected to decline by This was not our more than 8 million jobs peak to trough, y = -1.4x + 6.5 fathers’ or even and the unemployment rate will peak % Increase 2 Years After Trough After Years 2 Increase % R² = 0.4 our grandfathers’ well above 10% early next summer. While 0 recession, and thus GDP growth is expected to resume late 00 -01 -02 -03 -04 it will not be a in 2009, it will remain disappointingly % Peak-to-Trough Decline in Recession typical recovery. muted throughout much of 2010. Not The overhangs until 2011-2012 will growth accelerate financed by global investors, who have in the housing and vehicle markets and substantially, and the economy will not grown increasingly nervous about the financial system are serious and will return to full employment until well into America’s long-term fiscal challenges. take time to work through. Once that the next decade.8 Unless policymakers do something happens, however, the economy should Expectations that the Great Recession credible to address these issues, global gain traction quickly. Indeed, progress is will end soon depend on more stable investors could bolt, sending the dollar already being made, suggesting the upside household spending. It is the collapse in reeling and inflation and interest rates of the U-shaped cycle will become evident such spending, particularly among higher- soaring. The fragile financial system early in the next decade.5 income households, that has driven the would crumble, intensifying the credit Given the high uncertainty about severe downturn. These households have crunch and further impairing businesses’ which letter best describes the shape of ability to invest in the technologies the coming recovery, this article considers and innovations that drive productivity the entire alphabet. We begin with a 6 These probabilities are determined through the use of growth. The economy’s long-term growth consideration of the U-shaped cycle that Monte Carlo simulation techniques applied to the Moody’s potential would fall. Moody’s Economy.com deems the most Economy.com macroeconometric model of the U.S. economy. 7 To illustrate the breadth of the downturn: As of June, Between the optimists and pessimists likely scenario, with a 50% probability Moody’s Economy.com found all 50 states and more are those expecting something akin to a of occurrence. Given the preponderance than 380 metropolitan areas to be in recession. The only major industry groups currently growing are healthcare, U-shaped business cycle. The recession of downside risks to the baseline, the educational services, utilities, and the federal government. will end this year, according to this view, W- and L-shaped cycles, with a collective 8 Unemployment will not return to its estimated full- employment rate of 5.5% until late 2013. Prior to this but the recovery will be impaired in its 30% probability of occurrence, are recession, an unemployment rate of 5% was considered to early stages by the fragile housing and considered next. We conclude on a represent full employment. In this downturn, long spells vehicle industries. These interest rate- of unemployment are eroding many workers’ skills and marketability, making it harder to find another job. Reduced sensitive sectors have powered the early mobility due to the loss of housing equity—nearly 15 million parts of past economic upturns but seem 5 Views differ regarding the strength of the U’s upside.
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