As featured on p. 218 of "Bloggers on the Bus," under the name "a MyDD blogger."

Monday, May 11, 2009

The Lingering L-Shaped Recession

The OECD has joined the "green shoots" caucus by affirming that signs of a recovery are imminent, and the President of the European Central Bank is openly talking about central bankers scaling back their support once this recovery hits.

I really don't know what these people are talking about. If they want signs, I can give them signs. And there are just as many on the down side of the ledger as there are on the up side. There's the second wave of the foreclosure crisis. And let's add the credit card default crisis nipping at its heels. As more layoffs accrue, less people have the ability to pay their bills; that's just axiomatic. And the stress tests calculated credit card losses at a lower level of unemployment that what could easily happen in an adverse scenario.

The banks have an incentive to make profits, despite these scenarios that would eat into them, because they can reduce their capital needs if profit inch higher. There's only one way for them to do that - reduce lending and hoard money, along with gouging customers with fees to increase profits.

Finally, there's this historic shift from spending to saving that has accompanied economic insecurity. Now, in the long term, saving needs to increase to a more manageable level. But the paradox of thrift in the short term is harmful to any recovery.

Whatever the reason, I expect the saving rate to continue to rise over the next year or two. And that raises a question: what will be the impact on PCE (personal consumption expenditures) of a rising saving rate?

I created the following scatter graph for the period from 1955 through Q1 2009. This compares the annual change in PCE with the annual change in the saving rate.

Note that R-squared is only .125, so there are other factors impacting PCE (like changes in income!).

But a rising saving rate does seem to suppress PCE (as expected). If the saving rate rises to 8% by the end of 2010, this suggests that real PCE growth will be about 1% below trend per year.

So with wages barely rising, and a rising saving rate suppressing PCE, I'd expect PCE growth to be sluggish for some time. And since PCE is usually one of the engines of recovery (along with residential investment), I expect the recovery to be very sluggish too (no Immaculate recovery).

Let's recap: lower consumption, lower wages, higher unemployment leading to more credit card defaults, a potentially devastating second wave of foreclosures, and banks that must hoard capital and take profits, leading to less lending.

This is considered a GOOD outlook?

That only makes sense with a giant second stimulus, but the "green shoots" happy talk undercuts that option. Instead, I think Krugman is right - we're looking at half-steps that get the economy into some uneasy equilibrium without any serious recovery, and we just float for a decade.

"We're doing half-measures that help the economy limp along without fully recovering, and we're having measures that help the banks survive without really thriving," Krugman said.

"We're doing what the Japanese did in the nineties," he told a small group of reporters during a visit to Beijing.

He said it was not clear that China would suffer sub-par growth as a consequence of the fallout of the present crisis.

"I'm mostly worried that the U.S. and the euro zone will have Japanese-type lost decades," he said.

Krugman said he expected little or no employment growth this year or next in the United States, where the jobless rate in April hit a 25-year high of 8.9 percent.

Without a second stimulus, I don't know how this ends.

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