The deeper the slump, the bigger the bounce

Robert Barrie: Economic Outlook

The past isn’t always a good guide to the future, but nor is it a bad one. It is possible that this recession has been so different that we can’t learn anything about it — or the recovery that follows — by looking at the past: the uncertainty is too great. It is a view I sometimes hear, but not one that I share. All recessions have their own causes and contexts, but they also have a number of similarities. So do the recoveries that follow. One of the most over-used assertions in markets is that it’s different this time. The reality is that it’s different every time, but not completely.

One reason why recessions and recoveries are similar is that the impact of the initial shocks is often reduced, or reversed, fairly quickly. Having risen, oil prices or interest rates fall. A financial crisis is addressed by an effective policy response. The result — almost regardless of how the process starts — is a pattern of adjustment in which incomes, cash flow and confidence come under pressure and the economy as a whole does what any of us would as individuals in the circumstances — namely, spend less and hold on to whatever liquidity we can.

One of the features of this adjustment is that it turns out to be more about cuts in investment and inventory than cuts in consumer spending. Consumer spending is the largest part of the economy and the largest part of most commentary on it, but investment and inventory are the largest part of recessions. They are the more volatile parts of the economy. In the 12 most recent recessions in America, the eurozone and Britain, investment and inventory have accounted for more — sometimes many more — percentage points of lost output than consumer spending.

The present recession has followed the same pattern. It was supposed to be different this time — and more about the consumer — but the numbers say that it has been similar. That’s not to suggest that the recession has been anything other than dreadful for the consumer and consumer spending, but simply to note that, as in the past, it has been even worse for investment and inventory. If there is a difference, it is in the part played by inventory. In the recent past, it has been marginal. Now, as in the more distant past, it’s central to what is going on.

So much for the recession, what about the recovery? The good news is that it has probably started and that previous recoveries have tended to be strong. The average first-year growth rate in the 12 most recent recoveries in America, the eurozone and Britain has been 3% or so. The number depends on America — it is lower elsewhere — but it is a useful benchmark all the same. And severe recessions are often followed by strong recoveries. The most severe American recession in the sample was followed by the strongest recovery, and the mildest recession was followed by the weakest recovery.

It is not obvious at the low point of the recession, but things do get better from then on and, sometimes, surprisingly quickly. There are two things to emphasise in that context. The first, as we have suggested, is inventory — which, as more commentators are starting to realise, is a more or less arithmetic way of making recessions more severe and recoveries stronger at the same time. The second is the policy response. The worse the recession, the greater the policy response.

The popular view now seems to be that the recovery might be under way in Britain and elsewhere, but that it won’t be sustained. It’s all about inventory and only about inventory, the argument goes, and when stock levels have stabilised there will be no follow-through in investment or consumer spending. We will still need to rebuild our finances. It is possible that this will turn out to be the case, of course, just as the earlier more pessimistic views might have been right. If anything, however, the evidence is that inventory is still falling and that business and household finances are improving.

More to the point, the message from previous cycles is that recoveries that start and then stop are very rare. The pattern in our sample is that they start and then they continue. The average growth rates over the first three years are very similar to the average growth rate in the first year and the variability of growth falls over time. The fast ones slow down a bit and the slow ones speed up a bit. The recoveries become more, rather than less, similar over time.

In terms of where growth comes from, recoveries are a bit more representative than recessions, in that consumer spending typically makes the largest contribution. In the past, it has made a large contribution to the first year of American recoveries and that is a concern this time. It has made a smaller contribution in the eurozone and Britain. Investment and inventory have also been important in previous American recoveries and, as an offset to any weakness in consumer spending, they may play a larger role again this time.

As with growth itself, the variability of contributions to growth falls over time. In particular, recoveries that see weak contributions from consumer spending in the first year tend to see those contributions grow in subsequent years. The popular view of the current recovery that we describe above is possible, but it is not consistent with the current evidence or with anything in our sample of past cycles.

The other thing to consider — on which there is also considerable uncertainty — is inflation.

We find that core inflation has been lower one year, two years and three years after previous recessions than it was during them. That is consistent with the idea of spare capacity putting downward pressure on costs and prices, and in our view, this is probably what will happen now — we expect core inflation to fall over the next year or two. That, in turn, allows, and possibly even requires, the sort of policy response that supports recovery.

So, what would the pessimists say? They might say that recoveries from recessions caused by financial crises take longer and are weaker than average. They might tell us to take a closer look at Japan.

There is something in both of these arguments, but only up to a point. The recession has been worse than many earlier ones but the policy response has been greater than ever. It is far from clear what the net result is likely to be. As for Japan, we need to take a closer look, but hasn’t it just posted some strong figures for growth in the last quarter?

The conclusion is not that this cycle will be exactly the same as others, but that some of the reasons why they have been similar may still apply. In particular, the inventory cycle and the policy response could be more powerful than many expect. If we have a concern, it’s not so much about the prospect on current policy settings as about what happens when those settings change at some point in the future. That is a problem for another day, however. In the meantime, let’s hope that history continues to repeat itself. (Robert Barrie, The Sunday Times)


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