Real quick here because I am a bit under the weather
The snapback
This morning I retweeted a tweet by former Fed economist Claudia Sahm about the dire economic numbers in the US, saying:
Can we call this a depression already? What differentiates a deep recession from a depression? https://t.co/zjElEQNO59
— Edward Harrison (@edwardnh) April 30, 2020
Lakshman Achuthan responded, reminding me of the three D’s of depression, which are depth, diffusion and duration. I know Tim Duy was talking the same way a few weeks back. Here’s Lakshman’s analysis:
In terms of depth, this recession is extraordinarily deep. Already, 26.5 million people have filed for jobless claims, compared with a total of 8.7 million jobs lost during the Great Recession. And it’s not over.
Of course, a recession is really a vicious cycle, with declines in output triggering job losses, declining incomes and falling sales, which feeds back into a further drop in output.
This is integral to the diffusion of weakness across the economy – how it spreads like wildfire, cascading from industry to industry, and region to region in the country. In terms of diffusion, this recession is certainly severe, affecting a wide range of industries.
But on the third “D,” duration, this recession could be among the shortest on record.
Why? Leading indices suggest a self-feeding recovery. Lakshman deals in leading indicators constantly, as this is the essence of his business at ECRI. And the leading indicators point to the rapid recovery that economic models are spitting out.
The disbelief
Collectively, we have all questioned this V-shaped looking prognosis over the last several weeks.
It seems unrealistic on its face that we could have the most severe collapse in growth in 90 years and have that collapse be followed by a massive snapback so that we’re off to the races. It’s the same disbelief that we have collectively had about the equity markets’ snapback rally.
What gives? Here’s my take.
There will be a snapback, but one with many caveats.
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- When the economy loses 20% of its output. It falls to an 80% level. And an 20% rise from there only gets you to 96%. You’re still in the hole 4%. So you need to see a 25% snapback just to reach the starting point.
- The economy you want is one that would have grown though. So you must have even more of a catch-up to get you back on the same trajectory as you were on before. For example, if the economy could have grown 5% during the downturn and the catch up, you’ll need to grow 31.25% to recover from a 20% decline.
- No one is talking about these kind of numbers in the short term. Early this month, figures from Goldman Sachs showed GDP forecast to fall -9% in Q1 followed by a -34% fall in the Q2. After that, Goldman expected the US to see a spike of +19% in Q3. That’s not even close to getting you back to zero.
- The numbers out of China are suggesting the snapback won’t get you to 100% anytime soon. “For exporters, the worst of the downturn remains ahead, the polling suggests”. With the US and European economies in freefall, you can build inventories all you want; you’re not going to be able to sell them all. That’s what’s happening in the oil market by the way. These inventory builds meaning fire-sale prices for months to come.
Depression with a small ‘d’
So, let’s call these Goldman figures optimistic for now.
I’ve ‘unannualized’ these figures and what I calculate is Goldman basically saying that the economy will contract 10%, followed by an increase of 4.5%. That’s not anywhere close to where you want to be. Even in this outcome, it would take many quarters to recoup the economic losses, not to speak of re-attaining the prior economic trajectory.
Moreover, we’ve had 27.9 million people file initial unemployment claims in the United States (see my thread here on why I am using non-seasonally adjusted numbers). How many of these people will be unemployed for months and years?
If even one fourth of these jobs are actually lost permanently, we will be dealing with a shock that is as large as the Great Recession but happening in weeks instead of occurring over a year and a half, would be happening over the course of weeks.
— Adam Ozimek (@ModeledBehavior) April 30, 2020
This is why, when I look at the American economic picture, I talk of a depression with a small ‘d’. The economic carnage is so great, it’s hard to call this a recession, even if there is a snapback recovery. That’s not going to get you a V-shaped outcome. It’s a U- or L-shaped outcome. And before, it’s all over the third D, duration, will have been fulfilled to call this a depression.
My view
What separates a depression from a Great Depression is the infection of the financial system. The shorter the initial recession is, the less the financial system is crippled. And the less the financial system is crippled, the greater the chance we get out of this with a small ‘d’ depression versus a Great Depression.
I see financial system and real economy weakness as reflexive. Once they start feeding on each other, that’s when you’re in trouble. This is the takeaway from the Great Depression. I pointed this out in a twitter thread earlier this morning.
In the Great Depression, policy makers were more wedded to allowing economies to adjust, with the intent of wringing out excess. For me this is what turned a depression into a Great Depression once the financial system was infected.
This time, policy makers are doing “whatever it takes”. For example, the ECB’s Christine Lagarde explained this morning in her presser that the ECB will make sure its policy is transmitted ‘evenly across the euro area’. That’s code for making sure sovereign debt spreads don’t widen significantly. These comments, then, are a 180-degree pivot from what she said early in this pandemic about not targeting spreads.
So, with central banks adding massive liquidity and fiscal authorities deficit spending, the Great Depression outcome is a tail risk that seems to be off the table for now. Asset markets sense this and it that has buoyed shares.
But, eventually, the real economy and share prices will meet. Where they meet will depend on how well policy makers do in preventing this depression from becoming a Great Depression. Since a depression with a small ‘d’ is a base case here, most of the medium to long-term risk is to the downside for equities. Europe can still rally as it escapes its lockdown, something I recently discussed. But, longer-term there will be huge challenges.
The same is true for the US – but in much greater measure due to the lack of a social safety net wreaking havoc on the economy. The Adam Ozimek tweet above tells you why.