Anticipating the End of a Weak Recovery

By most estimates, the statistical recovery which began in the second half of 2009 in the US has been weak. Many had been talking about a V-shaped recovery early this year. However, given the magnitude of the imbalances in the U.S. leading up to recession, the underperformance of this technical recovery is not surprising.

Now, in April 2009 I said this would be a fake recovery even before it began. My issue was that the economy would be ‘ginned up by stimulus’ if you will but that we would get a supply side credit shock nonetheless. The systemic problems in the banking sector would still spell weak credit growth – even as banks recorded record profits. This seems to be what has occurred. And none of the systemic problems have gone away, not least the underwater second mortgages.

The household sector is troubled by indebtedness, which created a demand side shock for credit. In 2008 and 2009, consumers were reducing their debt loads in a manner consistent with the fall in nominal GDP, meaning debt to GDP levels were not falling that much.  However, household debt to GDP levels have continued to fall even as the economy has grown over the past year.

So what’s next?  A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom.  Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

However, longer-term things depend entirely on government because we are in a balance sheet recession.

–The recession is over but the depression has just begun, Oct 2009

Here’s the problem as I put it in that article:

1. The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect).  That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession
3. without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
4. Since state and local governments are constrained by falling tax revenue and the inability to print money, only the Federal Government can run large deficits.
5. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

Some of the shortfall in aggregate demand has been made up by the federal government. But the stimulus and aid programs that government has produced have been disproportionately directed at special interests, most critically the still weak banking sector. People have had their fill of this and stimulus has got a bad name. Therefore, the Obama Administration is constrained. I should also note that the Fed is equally constrained given its perpetual zero rate policy – what I am now calling PZ.

At this point, it is not clear that the baton of cyclical growth is being passed from government and inventory restocking to job increases and a consumer-led recovery.

Regarding jobs, I wrote recently that "I don’t see a 450,000 jobless claims number as recessionary in isolation." It’s the nexus of job stagnation, deleveraging and limited policy options which is worrying.

Q3 2010 GDP growth may come in below 1% annualized. That is extremely weak. The U.S. economy is already operating at stall speed with consumers still in deleveraging mode. States and municipalities are shedding workers. Stimulus has been the only thing holding things up.

When thinking about economic cycles, normally you see jobless claims start to rise before a serious decline in output comes to pass. Unlike the unemployment rate, the change in (continuing and initial) claims are coincident or lead rather than lag the onset of recession. They usually start rising well before the recession. (See here: Another Perfect Recession Indicator)

In the past I have seen a sustained rise in initial claims of more than 50,000 in a year’s time as a recession lock. Businesses at cycle ends are conditioned by a rising economy and thus reduce output and staff only with a considerable lag. So, if they are shedding that many more workers, you know output is going to fall.

However, I anticipate the change in jobless claims will be lagging like they were in 1981. In this cycle, businesses have not been conditioned to an improved economy and I believe they will act rather quickly to any dip in output.

What could cause that dip? Housing decline, tax increases, protectionism, etc. And if that dip occurs, businesses would react. Given consumers are already deleveraging, the resultant consumer retrenchment would induce a severe decline in output and rise in unemployment. This, of course, will make obvious the gamble Obama, Geithner and Summers have taken on ‘banking’ the recovery and Obama’s Presidency on recapitalizing the banking sector instead of job creation since the banking sector would not be able to withstand the carnage to its balance sheet of another downturn.

I will be watching the change in jobless claims numbers, but in this cycle, that may not tell me anything until it’s too late. For all of us, that means we have to look elsewhere for signs of recovery – housing, business investment and government policy.  The President’s recent tax incentive for business investment is designed to help here. But it is too little and too late in my view, especially given the overcapacity we already have. Why would business want to increase investment yet?

As I said in March when commenting on some of Felix Zulauf’s statements in the Barron’s roundtable, my sense is that the secular forces of deleveraging are too powerful to be overcome by the thrust of recovery’s cyclical forces without significant government aid. My hope, however, is that these other areas like business investment will turn up enough to keep us going to where job growth can begin.