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The shape of the economic recovery

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COMMENTS

6 May 2009 09:30

While the stronger numbers now coming out of China suggest that Beijing’s stimulus plan is getting some traction, the consensus view still seems to be that a recovery for the world economy remains heavily dependent on developments in the US, and hence that the nature of the US and global economic recoveries will be correlated. 

Economy-watchers are now busy scanning the incoming US data for signs of green shoots and this has breathed new life into a familiar debate: what shape will the US recovery take, once (if) it arrives?

There is the usual alphabet soup of contenders: Us, Vs, Ws and Ls, along with some slightly more esoteric contenders like the D (for Great Depression), the hockey stick, and the inverted square root. However, three candidates — V for a relatively rapid recovery, U for a more subdued return to growth and L for a prolonged period of stagnation (think something along the lines of Japan’s lost decade) — cover most of the likely scenarios.

Part of the case for a V-shaped recovery rests on the empirical proposition that the historical US data show that steep downturns tend to be followed by sharp upturns — the so-called Zarnowitz rule highlighted by Michael Mussa. 

Another important part of the case rests on the old Wall Street adage ‘Don’t fight the Fed’: Ben Bernanke’s Federal Reserve has delivered an extremely aggressive response to the current downturn, with the nominal fed funds rate held effectively at zero since 16 December last year and the FOMC supplementing this with a series of additional measures designed to pump money into the economy. With this monetary stimulus also being supported by fiscal policy, the US authorities are trying to refloat the economy on a surging tide of liquidity and government spending.

The case for a U-shaped recovery starts from the proposition that the current recession differs enough from its predecessors to make the Zarnowitz rule a flawed forecasting guide this time around. While the majority of US postwar recessions have been the result of Fed actions to tame inflation, the current downturn has its origins in a major financial crisis. In addition, it is taking place against the backdrop of a synchronised global downturn. 

The combination of these two factors argues both for a deeper recession and a more subdued recovery than the historical average. While policy stimulus will certainly help, there is a clear risk that the efficacy of monetary policy is being blunted by the damage to the financial system, while fiscal stimulus will only partially offset the fall in private sector demand created by the desire on the part of households to save more to rebuild destroyed wealth.

The final scenario calls for an L-shaped pattern of economic performance, where policy stimulus proves able to do little to offset a sustained process of private sector retrenchment and deleveraging against the backdrop of a financial sector that remains impaired for a prolonged period of time.

At the moment it’s still possible to tell plausible-sounding stories based on any one of these scenarios — hence the wide range of views at present about US economic prospects. For what it’s worth, and despite the current bout of market optimism, I think that for now the U looks to be the most likely of these three contenders.

Photo by Flickr user ashleyv, used under a Creative Commons license.

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