|A rapid recovery based on stimulus packages may conceal some core problems [GALLO/GETTY]|
Spring has arrived in the US, China and Europe, and policy-makers are seeing ‘green shoots’.
Lawrence Summers, Barack Obama’s economic adviser and the former US treasury secretary, says the sense of freefall in the US economy should end in a few months.
Economy watchers and institutions, from the Organisation for Economic Co-operation and Development (OECD) to the European Central Bank (ECB), are busy scanning incoming world data for signs of these ‘green shoots’ and this has breathed new life into a familiar debate: What shape will the recovery take once it arrives?
The debate is taking on an alphabetical twist, but luckily you do not have consider all 26 letters, just four – V, W, U and L.
A ‘V’-shaped recovery means that the economy will immediately recover and enjoy a steep bounce back. This is what optimists, or those who have been termed ‘green shootists’, hope will happen.
A ‘U’ means an economy that will take a bit longer to recover, with growth that is more subdued.
A ‘W’ is a rollercoaster ride – just when we think the recession and its troubles are behind us, we drop again before resuming growth.
And finally, ‘L’ means that we flatline – we do not fall, but we do not grow either. Essentially we crawl at the bottom for a good while, making it a deep and prolonged recession (think something along the lines of Japan’s ‘lost decade’).
‘V’ and ‘L’ cover most scenarios and both of these possible outcomes are jostling for position. So what are the cases for each?
‘Green shoots’ V
The case for ‘V’ relies on history and economists, as much as lawyers, like precedence.
All historical observations in the US and most of the West have shown that steep downturns, like the one we are experiencing right now, have always been followed by sharp upturns – the so-called Zarnowitz rule (named after business-cycle economist Victor Zarnowitz).
They argue that in the business-cycle history of the US, at least as far back as economic data goes (which is to 1925), all recessions have been followed by a ‘V’-for-Victor bounce back, with only one exception.
This exception was a very special event that followed the end of the second world war between 1945 and 1946.
Michael Mussa, a former Economic Counsellor and Director of the Department of Research at the International Monetary Fund (IMF), argues that people were so happy to relax after working so hard during the war effort that real Gross Domestic Product dropped by 13 per cent, as private consumption and investment could not offset the impact of the decline of the war effort.
That one recession followed an ‘L’-shaped recovery, but all the recessions that were to follow, including the 2001 recession, followed a ‘V’ recovery.
The ‘V’ supporters argue that other countries, such as Japan, were able to leap out of recession as they relied on selling their exports to the rest of the world. This happened to Japan in the 1990s and to the US in the 1980s.
Another important part of their case rests on the adage “don’t fight the Fed”.
Ben Bernanke’s Federal Reserve has delivered an aggressive response to the economic malaise, with the nominal funds rate held effectively at zero since December 16, 2008.
With this monetary stimulus also being supported by fiscal policy, the US authorities are trying to refloat the economy on a surging tide of liquidity and government spending.
The case for ‘L’
Those who believe that a cold economic winter lies ahead for us disagree vehemently with this point.
They argue that the rule book on ‘V’-style recoveries has to be thrown out because this recession is unlike any other we have seen.
In large part this is because it is a global downturn – every continent has been affected, which means that no one can truly afford to buy the other’s goods.
Previous recessions, they say, involved one or two countries at a time, so the economically depressed countries were able to sell their exports to the rest of the world, which was not affected by the economic malaise.
But this time around we are all hurting, and until we find a planet we can export to, we will be in this recession for a fair while.
Financial sector involvement
Moreover, they say that the extent of the involvement of the financial sector makes this recession even more unique and will make it all the harder to overcome.
At no time in history has the financial system played such a huge and powerful role in the economy.
Since 1980, most Western economies have moved much more of their GDP into finance. This makes the current problems much harder to address.
In its latest Global Financial Stability Report, the IMF now estimates overall losses in the financial sector of $4,100bn. The next estimate will presumably be higher.
Moreover, there are issues that go beyond the banking system with regard to balance sheets.
The balance sheets of consumers and that of businesses are highly damaged, and this makes the similarities to Japan’s ‘lost decade’ all the more relevant here.
It is the US’ demand that spurs the world’s growth – its total private sector debt rose from 112 per cent of GDP in 1976 to 295 per cent at the end of 2008.
Financial sector debt alone jumped from 16 per cent to 121 per cent of GDP over this period.
This balance sheet disorder signals that it will take much more than government fiscal stimulus packages or innovative monetary policy, such as quantitative easing, to get us out of this mess, and hence the recession could be a protracted affair.
The fear right now is that if there is a turnaround, ‘V’-style, people will throw caution to the wind and assume that they can go back to business as usual.
But we have now seen that that model of doing business is unsustainable.
Any positive bounce out of this recession, I believe, will be short-lived and a result of the fiscal stimulus packages that governments have literally been drowning their people in.
The truth is that the financial system is incredibly unhealthy.
In addition, there is another point that we rarely hear about – the reasons why individuals became indebted have not been dealt with.
There is an assumption that the subprime mortgage, which started this whole global recession, was a result of people taking out loans that they could not afford to pay back.
Barack Obama, the US president, has said that this was due to financial literacy – almost hinting that the blame lies with these people.
Debt from necessity
I disagree. People over-extended themselves when it came to loans and became over-indebted, not out of ignorance or choice, but necessity.
People had to borrow in order to get by. In blunt terms people borrowed to survive.
In the US, the ratio of debt to disposable income is 130 per cent, in the UK it is 150 per cent. Why is that?
Well, because incomes in the US and the UK have been stagnant or declining since the 1970s.
This means that people’s capacity to just get by – to go to college, to buy a house – was compromised, and hence, they were pushed to turn to banks to be able to afford these things.
Until household incomes increase, the economies of the US and the UK will always be on shaky ground and will continue going from one recession to the next.
An ‘L’-shaped recovery looks likely because Americans have learnt a tough lesson from this crisis and are beginning to save. They cannot, therefore, be relied on to spend their dollars and save the world.
But an ‘L’ might not really mean the end of things for us – it just depends what we do during these hard times.
If we use that time to rebalance the economy, stop being so reliant on the banking sector and maybe start shifting our economy into industry, even green technologies, then maybe these ‘green shoots’ can really take real root.