The prospect for recovery

    Notwithstanding the recent strong Q2 GDP data from the eurozone and UK, signs of economic weakness have led to fears that there could be a ‘double dip’. History shows recoveries are never in a straight line, so fears of a relapse are not unwarranted as output declines can and do quite frequently occur in recovery phases (though not a return to outright recession). In some cases, there is a bounce-back effect as the recovery is almost a mirror image of the downturn. In other cases, the downturn may be long and drawn out due to the adjustments that have to take place to ensure recovery. Thus, in order to understand the recovery, you need to understand the factors shaping the shock. We look at some of the factors affecting this downturn in order to better understand the prospects for recovery. Naturally, this begs the question of what distinguishes this particular economic downturn from previous ones?
    Studies have shown that recoveries differ according to the nature of the shock that caused the initial downturn. These shocks can range from financial, fiscal and monetary, to external demand and oil price effects. Analysis by the IMF has shown that economic shocks caused by financial crises result in economies taking longer to recover than from any other shock. So called ‘normal recessions’ are typically over in a year and a half whereas those related to financial shocks take three years or so.
    So what differentiates financial shocks from the other episodes? Not surprisingly, the short answer is credit booms, house price bubbles, low unemployment, strong demand for goods and services, external deficits and overvalued exchange rates. It is probably not worth debating the causes of the current crisis as it is well known that we have witnessed the biggest boom and crash in financial markets since the 1930s depression. What is more, the period preceding it saw excessive borrowing and spending by households and companies, which fed an unsustainable economic boom that ended in the recession we are still recovering from.

    The key assumption is whether the economic downturn starts at or about the same time as the financial crisis. Of course, in this downturn, the financial crisis started before the economic crisis, so the relationship seems to be holding in this instance. The UK and US recessions are already in the ‘financial shock’ category, with the UK in particular well below its pre-crisis peak and on track to surpass the 1980s downturn in its longevity. For the US, it is already the worst post war downturn though the level of output may hits its pre-crisis peak by year three, in line with the average of financial crises related recessions. Taking the US and the UK as examples of two key economies where there were excessive credit booms and the current recovery is two years after the recession began (taking the onset of recession as the first half of 2008), it is clear that this recovery is in fact very much in line with those associated with financial crises.

    In that sense, this recovery is proceeding as expected from a recession associated with a financial crisis. True, this implies that observers of this recovery phase are incorrectly linking it with previous downturns not associated with financial shocks. And so in this sense they, rightly, draw the conclusion that the downturn is worse than the average of the last three recessions and the recovery is slower and more at risk. However, if observers were to compare the recoveries underway in the US and UK not with the previous three recessions but with those associated with financial shocks, then they would see that it is proceeding pretty much as history would suggest and so should not be surprised by how it is unfolding.

    Hence, the US is experiencing its longest and deepest post-war economic downturn for a good reason; it has also experienced its sharpest and biggest boom in construction and financial sector activity since then as well. However, the UK and US have been affected slightly differently by the financial crisis. In the US, the worst of the excesses of the credit boom were shown in bubbles in property prices, in strong demand for goods and services and an excessive external deficit. Hence, the detail of the effects of the recession by sector shows that it is in these areas where most of the fall-out is being reflected. Admittedly, US services output has held up well in the two years since the recession began but manufacturing and construction are seeing their worst downturn post war. For the UK, the distinguishing feature of this downturn has been its impact on services, where this is by far its worst performance in any recession since WW2.
    All this implies that monetary policy is not working as well as would be the case in a ‘normal recession’ and so recovery is taking longer. The lesson: expect policy to be loose for a longer period than in previous downturns and the economic recovery to be slower and more protracted. Interestingly, this is pretty much what we are seeing currently. In the UK, we expect GDP growth to slow to between 0.25%-0.5% in the third and fourth quarters. If realised this would leave GDP growth for the calendar year as a whole at 1.5% with expectations of a modest pick up in GDP growth to 2.0% for 2011, although there is a risk that it could come in weaker if the deterioration in sentiment continues over the coming months.

    Source: FI Bank Newsletter, Date unknown.

2/25/2018 1:41:39 AM