Tuesday, February 03, 2009

The Bottom Beckons

Almost everything I see in my day to day business view (admittedly a somewhat narrow one) indicates that this economic downturn is going to be long, painful, and deep. The way companies are cutting back spending, shedding jobs, and cancelling projects says that they have dim views on the economic prospects for the next couple of years. You see this in almost all of the current economic news and indicators as well.

Yet despite all this evidence of an extended downturn, I continue to hear Pollyannaish economic predictions that clam that this is as bad as it's going to get and we should expect to see a rebound as early as the third or fourth quarters of 2009. In today's WSJ, Carmen Reinhart and Kenneth Rogoff warn against such optimism and explain why, based on comparisons with previous financial crises, they Expect a Prolonged Slump:

Let's start with the good news. Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008, as many on Wall Street do, the case for an end in 2009 is less compelling.

On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels.

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough -- dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks.

Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits.

No amount of stimulus--either real or the artificial kind being peddled today--is going to change these underlying dynamics. At this point, we should probably just acknowledge that we haven't hit bottom yet, that we need to before we can begin to recover, and do our best to ride it out from here. In fact, such short term spending risks longer term damage to the economy:

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role, as we are about to witness in spades here in the U.S. with the passage of a more than $800 billion stimulus bill.

Needless to say, a near doubling of the U.S. national debt suggests that the endgame to this crisis is going to eventually bring much higher interest rates and a collapse in today's bond-market bubble. The legacy of high government debt is yet another reason why the current crisis could mean stunted U.S. growth for at least five to seven more years.

So we either bite the bullet and tough it out for a few years or try to spend our way out and end up with prolonged stagflation? Neither choice is all that appealing, but they actually reflect reality instead of pretending that recovery is just around the corner.

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