Wednesday, September 22, 2010

With Recession Over, What's Next?

Now that the US recession has officially been declared as being over, the most obvious and pressing question is where we go from here?

As there are confusions about what a recession or recovery actually means (see the previous post), there are just as many confusions concerning whether we are actually in a recovery or a recession. I have provided a chart that will help to illustrate this point (click the chart to enlarge it).

I think it is safe to say that generally, most people refuse to believe the pronouncements of economists concerning when an economy is in the very early stages of either recession or recovery. Consider early recession in the chart. Note that the economy is not very far from its peak in economic activity. So, when economic data are released, the numbers are still very good in a historical context. In fact, unless you focus on what economists refer to as leading economic indicators, the numbers will show an economy that is still climbing the activity "hill" (i.e., to the left of the peak), making it even more difficult to assess what is actually taking place. Perhaps the best example of this is the one measure the general population focuses on most -- the unemployment rate. This is a lagging indicator, meaning its level at present reflects what happened in months past. Remember: a recession is NOT defined as a level of diminished economic activity. As the National Bureau of Economic Research (the "dating" body for economic cycles) points out, it is instead a period of diminishing activity. This highlights the distinction between levels and rates of change that I discussed in the previous post.

Right now, nationally at least, we find ourselves in the early stages of a recovery. Once again, look at the chart above. In the early stages of a recovery, an economy is close to the "bottom" of economic activity. The numbers that are released are therefore not going to be very good, and after a recession period, often discouraging. Of course, if you focus on lagging indicators, you will almost certainly conclude that we are still in a recession.

At this point, I need to reiterate that contrary to popular "wisdom," being in a recovery does not necessarily require a return to "normal" times and historical averages (or above) of economic variables. It might. But generally it takes some time to get back to "typical" levels. The next chart will help to explain this.

As this chart should illustrate, not all recoveries are alike. Each path reflects how rapidly economic activity will be rising in the future. Historically, when there is a very deep national recession like the one we just had, the economy rebounds quickly. This leads to a "V" shaped recovery (the green line). It doesn't take all that long to return to "normal" levels of economic activity. In that situation, a recovery feels like a recovery.

But recovery paths are different since not all recessions are the same. Global recessions occur over longer periods and are generally more damaging than more "typical" recessions. When there is a global recession with major financial problems, as the one we just had, the pace of recovery tends to be slow and it takes a longer time to return to "normal" levels of economic activity (the red line). Consider that at present, individuals are spending less, saving, and paying down debt. Banks have lowered leverage. All of this is very positive in the medium to longer term, but it extracts a cost on the rate of economic growth in the short term. Add to this  the fact that banks aren't lending as much as they might have in previous recoveries, and you get what Mohammed El-Erian of Pimco refers to as "The New Normal" (click here for a video of El-Erian explaining this concept). He and I are somewhat concerned with the possibility of deflation in the near-term as well.

So, where does all of this leave us? What are you to think? Hopefully you are now more aware of  the basics of what is really going on, what an early recovery means, and the possible paths the US economy might take. THE question is which path will be the one our economy follows. Let me be very honest about this: economists, including me, don't really know the answer to this, in spite of all our forecasts and predictions. In this context, let me state one of my favorite sayings: CERTAINTY IS AN ILLUSION. Any forecast, no matter who makes it, is essentially a scenario. It assumes what the areas are that will be the most important over the forecast period, how each of those areas will actually change, and the interactions between and among them. Obviously, there are numerous sources of potential error.

In a period of such uncertainty, where things seldom appear to be what they actually are, many persons are all too willing to step forward with their "solutions." While these might sound good, or appeal to the increasingly subjective notion of "common sense," they too are based on scenarios. So, they might be right. Or, they might be wrong. Let me recommend that you critique any or all of these within the context of one of my favorite sayings: "Complex problems have simple, easy to understand, wrong answers."

Let me finish by acknowledging that at this point you are no doubt wondering where I stand on the future path of economic growth. I will outline this in the coming days (it's time for me to get to class). Before doing that, I need to apply the information in these last two posts to what is occurring in Rhode Island. Stay tuned!

No comments:

Post a Comment