NEW! CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Tuesday, November 03, 2009

NY Times Leonhardt: The Optimistic View

by Calculated Risk on 11/03/2009 09:43:00 PM

David Leonhardt at the NY Times gives "equal time" to a more optimistic outlook: Through a Glass Less Darkly

In the fall of 1982, with a long recession ending but the unemployment rate heading toward 10 percent, The New York Times ran an article titled “The Recovery That Won’t Start.”

It quoted prominent economists who worried that “the recovery may amount to nothing more than a few quarters of paltry growth — and possibly not even that.” The economists, the article noted, had “growing doubts about whether the mechanisms of economic recovery will — or can — operate as they have in other postwar business cycles.”

Over the next two years, the American economy grew at a blistering annual rate of more than 6 percent.
People tend to become overly pessimistic at the end of a recession, partly because they can see that the forces behind the last boom — housing and mortgage lending, in this case — won’t be around for the next one. If anything, the excesses from the last boom seem likely to hold back the economy for years to come. People are left to wonder where future growth will come from.

I want to take a stab at that question today. To be clear, I am not predicting a boom over the next two years. I’m just trying to give equal time to the side of the economic ledger that often doesn’t get discussed until after the fact.
Leonhardt goes on to discuss a few reasons the economy might grow quicker than many expect: consumption in China, pent-up demand in the U.S., more stimulus spending, and some surprising unknown innovation.

My comment: Usually the deeper the recession, the more robust the recovery. So why is it different this time?

First, this recession was preceded by the bursting of the credit bubble (especially housing) leading to a financial crisis. And there is research showing recoveries following financial crisis are typically more sluggish than following other recessions. See Carmen Reinhart and Kenneth Rogoff: Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison

Second, most recessions have followed interest rate increases from the Fed to fight inflation, and after the recession starts, the Fed lowers interest rates. There is research suggesting the Fed would have to push the Fed funds rate negative to achieve the same monetary stimulus as following previous recessions (see San Francisco Fed Letter by Glenn Rudebusch The Fed's Monetary Policy Response to the Current Crisis). Welcome to ZIRP! (Note: Professor Taylor disagrees on the size of the negative Fed funds rate).

Third, usually the engines of recovery are investment in housing (not existing home sales) and consumer spending. Both are still under severe pressure with the large overhang of housing inventory (record vacancies rates!), and the need for households to repair their balance sheet (the saving rate will probably rise - slowing consumption growth).

We are a long way from normal.