Monday, April 06, 2009

Altman: Not a normal cyclical recovery

by Calculated Risk on 4/06/2009 11:55:00 AM

Roger Altman, former deputy Treasury secretary, writes in the Financial Times: Why this will not be a normal cyclical recovery (ht Jonathan)

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out ...

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

... To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. ... household debt reached 130 per cent of income in 2008.

This debt derived from Americans spending more than their income, reflecting the positive wealth effect. Households felt wealthier ... Now that wealth effect has reversed with a vengeance. ... household balance sheets will not be rebuilt soon. Home values will keep falling through mid-2010 and there is no precedent for equity markets, still down 45 per cent from their peak, to make those losses up in just two years. It is illogical, therefore, to expect a full snap-back in the consumer sector in 2010 or 2011. This alone mandates a drawn-out, weak recovery.

The second key sector is the financial one. ... losses are eating into banks’ capital and shrinking their capacity to add assets. Funds from the Troubled Asset Relief Program are only replacing lost capital, not increasing it. When might they end? With key categories of toxic assets still losing value, the answer is: not soon. The scale of lending needed to support a normal cyclical recovery will not materialise.

A third constraint on recovery may involve the federal balance sheet. The fiscal and monetary engines are currently on full throttle. But, within two years, concerns over budget deficits and inflation may revive, compelling the Federal Reserve to raise interest rates and Congress to adopt deficit reduction steps. These actions, contractionary by definition, could occur before a full recovery has asserted itself. On that basis, the federal balance sheet would also limit a full recovery.
Also, in a typical cycle, residential investment (mostly new home construction and home improvement) leads the economy out of a recession. This time there is still too much excess inventory - especially distressed inventory - for any meaningful recovery in residential investment.

So even if the economy bottoms later this year, the recovery will probably be very sluggish for some time.