The Resilience of Capitalism

Paul Ormerod wrote in the Financial Times that we should not underestimate the resilience of capitalism to bounce back sharply from a deep recession, as we are experiencing today.

The fall in output in the current recession has been sharp. In the US, for example, gross domestic product fell at an annual rate of just above 6 per cent in the two most recent quarters. In Japan, GDP is down by nearly 9 per cent on its 2008 first-quarter peak. The latest UK data suggest output is nearly 6 per cent lower than a year ago, the sharpest fall since 1931.

The conventional wisdom is that the steepness of the fall means the recession will be long, and that the recovery when it happens will be anaemic.

In the UK, for example, it is argued that GDP per head would take five years to get back to pre-recession levels. The UK government projects a fall in GDP of 3.5 per cent for 2009, followed by a rise of 1.25 per cent in 2010 and a 3.5 per cent upswing in 2011. But these official forecasts have been widely criticised as too optimistic.

In the US, the consensus among forecasters is that growth at or near trend will not resume until the second half of 2010 and that the 2008 second-quarter peak level will not be regained until the first half of 2011.

As late as the autumn of 2008, economic forecasters in general were far too optimistic about 2009. Are these same forecasters now too pessimistic about recovery? The historical evidence reveals a typical pattern of recession and recovery that suggests this may be so. Very few recessions last longer than two years. And most recoveries, once they start, are strong.

Since the late 19th century, there have been 255 recessions in western economies. Of these, 164 have lasted just one year and only 32 have lasted for more than two years. In other words, two-thirds of recessions last a single year, and only one in eight lasts more than two years.

The pattern of duration is virtually identical regardless of the size of the initial shock. Even when the initial fall in output has been more than 6 per cent, 70 per cent of recessions have lasted just one year. Even in the 11 examples where the initial fall in GDP was more than 8 per cent in a year, eight recessions only lasted that single year. This does not of course guarantee that the current recessions in western economies will be short-lived, but, equally, the speed of the fall does not imply they will be long.

An analysis of recessions since the second world war shows that those lasting one year or less typically end more abruptly. The average growth rate in the year after such a recession was 3.5 per cent, and in the subsequent year 3.8 per cent. This is compatible with the view that short recessions are essentially inventory cycles. Once inventories are reduced to satisfactory levels, normal production levels resume, and fixed capital investment expenditures postponed during the recession are carried out.

The 4.8 per cent GDP growth rate projected by the UK government from 2009 to 2011 has been criticised as too optimistic. It is in fact rather modest in this wider context.

Recovery was rapid even after the Great Depression. The nature of the economic catastrophe that started in 1929 varied enormously across countries, both in size and duration. The UK escaped relatively lightly with a 6 per cent fall in output spread over two years. In Japan, Denmark and Norway the recession lasted only a single year. But in Germany, Austria, Canada and the US, the cumulative fall in output was between 25 and 30 per cent, with the recession lasting four years in the latter three countries and three in Germany.

However, once the recovery began – in different calendar years in different countries – the average rate of growth was strong. GDP growth in the first year after the Great Depression averaged 4.7 per cent, followed by 4.6 per cent in the second and third years.

Stock prices are soaring, but consumer confidence still weak

MarketWatch reports that stock market investors should be wary of over-optimism since consumer confidence levels are still falling.

With a second survey in less than one week showing consumer confidence falling, some strategists believe that investors' market expectations are running well ahead of economic realities and that a wake-up call might come after earnings season.

Since the flow of corporate results started in early July, the broad S&P 500 index has rallied 11%, with investors focusing on a large number of key results that have easily topped lowered market expectations.

But critics have signaled that many of the positive surprises have been based on cost-cutting measures while few firms have signaled any improvement in business conditions. And consumers' willingness to spend remains key to that process.

"Consumer confidence numbers are dropping in part because of future consumer expectations and investors should be heeding the warning," On Tuesday, the Conference Board said U.S. consumer confidence fell for a second month in July, underscoring still-gloomy sentiment about the U.S. economy.

"However, the markets may be setting up for a fall decline, as expectations are getting well ahead of economic reality."

Last Friday, the University of Michigan and Reuters also said consumer sentiment fell in July. Similarly, Gallup's latest weekly poll showed confidence confirmed a July drop following a decline in June. And while confidence remains "significantly higher" than a year ago, Gallup says the survey suggests "no sign yet of a similar uptick in job creation or consumer spending."

One area of confidence for consumers is the stock market, with 48% of Americans polled by Gallup in June expecting stocks to rise over the next six months. But the same poll revealed 57% of Americans think unemployment will also rise over the same period, sapping willingness to spend. Historically, consumer spending has made up about two-thirds of U.S. gross domestic production.

Economic models need an overhaul

Paul De Grauwe, professor of economics at the University of Leuven and the Centre for European Policy Studies made some interesting points about the different economic schools of thought, which in his opinion needs some re-think. The article appeared on FT.com:

We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called “animal spirits” are fundamental forces driving macroeconomic fluctuations.

The basic error of modern macro-economics is the belief that the economy is simply the sum of microeconomic decisions of rational agents. But the economy is more than that. The interactions of these decisions create collective movements that are not visible at the micro level.

It will remain difficult to model these collective movements. There is much resistance. Too many macro-economists are attached to their models because they want to live in the comfort of what they understand – the behaviour of rational and superbly informed individuals.

To paraphrase Isaac Newton, macroeconomists can calculate the motions of a lonely rational agent but not the madness of the crowds. Yet if macroeconomics wants to become relevant again, its practitioners will have to start calculating this madness. It is going to be difficult, but that is no excuse not to try.

Shareholding equal ownership, but in practice?

David Pitt-Watson, an ex-fund manager, made the following comments which appeared on FT.com:

Our system of capital markets is not one that focuses on ownership. Investors are encouraged to diversify in order to avoid risk, but not to manage it. Having diversified, shareholders then trade shares. Many know little about the companies they invest in, because they invest in so many. Those who do know sell their shares as soon as problems arise. Thus we have created ownerless corporations. Among such corporations, as Adam Smith would remind us, “negligence and profusion” will prevail.

So what can we do? Well, doubtless there will be pressure on investors to play their proper ownership role. Companies will need to understand investors better, think through their requirements and prescribe the right solutions. As a fund manager, I rarely came across companies that, when they came to present their results, had that on their agenda. Few asked what sort of fund I ran, why it had bought the shares or who its investors were.

Too few companies focus on using their operating and financial review and their accounts as honest and open reports “for the owner”. Indeed, their understanding of their shareholders as owners belied their apparent commitment to shareholder value. After all, no one today would treat seriously someone who said they were delivering value for their customer when no market research had been carried out.

Resolving these problems will require all of us to make the chain of ownership work: from the pension fund to the fund manager to the board. Some may say that this is impossible if the investors are short-term or ill-informed. But if the directors think of themselves as professionals, like doctors, that would be a helpful model. After all, we defer to our doctor’s judgments, even if they do not accord with our own views. But we only trust those who have asked about and understood our condition, and who can explain why their treatment will be effective.

The benefits of a more professional relationship would be enormous: a brake on excessive risk-taking, a respect for sceptical criticism and a joint commitment to well-judged strategy.

China: Leading the world to economic recovery?

China is undoubtedly the world's best performing major economy in the world with the release of the last economic growth figures. Financial Times reported recently on the latest figures:

China’s economy is on track to hit the government’s growth target of 8 per cent this year following increased government spending and a surge in bank lending in the second quarter.

The economy expanded at an annual rate of 7.9 per cent in the three months to the end of June, with investment, industrial production and retail sales all contributing to higher output.

China’s accelerating growth has already lifted prices of commodities such as iron ore and copper and boosted economic output of raw materials exporters such as Australia and Brazil.

The speed of the Chinese recovery, without an accompanying boost in demand from advanced economies in North America and Europe, has surprised economists and led the International Monetary Fund to revise higher its outlook for the world economy earlier this month.

The bank lending and fiscal spending has driven fixed-asset investment, the prime engine of growth, up 33.5 per cent in the first half of the year compared with the same period in 2008.

Government incentives for consumption, such as rebates on buying cars and white goods, helped support retail spending, which expanded 15 per cent in the first six months of the year.

Inflation: The real enemy

Alan Greenspan, former chairman of the Federal Reserve, is of the opinion that inflation will pose serious challenges to central banks in the years ahead. He wrote the following article that appeared on FT.com:

The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. I conjectured over a year ago on these pages that the crisis will end when home prices in the US stabilise. That still appears right. Such prices largely determine the amount of equity in homes – the ultimate collateral for the $11,000bn of US home mortgage debt, a significant share of which is held in the form of asset-backed securities outside the US. Prices are currently being suppressed by a large overhang of vacant houses for sale. Owing to the recent sharp drop in house completions, this overhang is being liquidated in earnest, suggesting prices could start to stabilise in the next several months – although they could drift lower into 2010.

In addition, huge unrecognised losses of US banks still need to be funded. Either a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries would address this impediment to recovery.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the “green shoots” spotted in recent weeks to wither.

Stock prices, to be sure, are affected by the usual economic gyrations. But, as I noted in March, a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.

The short-term dangers of deflation and longer-term dangers of inflation have to be confronted and removed. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply.

Inflation is a special concern over the next decade given the pending avalanche of government debt about to be unloaded on world financial markets. The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.

Moreover, unless US government spending commitments are stretched out or cut back, real interest rates will be likely to rise even more, owing to the need to finance the widening deficit.
Government spending commitments over the next decade are staggering. On top of that, the range of error is particularly large owing to the uncertainties in forecasting Medicare costs.

Fears of an eventual significant pick-up in inflation may soon begin to be factored into longer-term US government bond yields, or interest rates. Should real long-term interest rates become chronically elevated, share prices, if history is any guide, will remain suppressed.

The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation. Even absent the inflation threat, there is another potential danger inherent in current US fiscal policy: a major increase in the funding of the US economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of “creative destruction” – the private sector market competition that is essential to rising standards of living.

However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.

Underestimating the impact of unemployment numbers

Mohamed El-Erian, famed author of "When markets Collide" and chief executive of PIMCO, expressed recently his concern in a Financial Times article on what U.S. unemployment numbers actually mean for economic growth prospects.

What if the US unemployment rises above 10 per cent and stays there for an extended period?

The unemployment rate is traditionally characterised as a lagging indicator and, as such, is viewed as having limited predictive power. After all, unemployment is a reflection of decisions taken earlier in the cycle so the rate always lags behind the realities on the ground – or so says conventional wisdom.

This conventional wisdom is valid most, but not all of the time. There are rare occasions, such as today, when we should think of the unemployment rate as much more than a lagging indicator; it has the potential to influence future economic behaviours and outlooks.

Today’s broader interpretation is warranted by two factors: the speed and extent of the recent rise in the unemployment rate; and, the likelihood that it will persist at high levels for a prolonged period of time. As a result, the unemployment rate will increasingly disrupt an economy that, hitherto, has been influenced mainly by large-scale dislocations in the financial system.

In just 16 months, the US unemployment rate has doubled from 4.8 per cent to 9.5 per cent, a remarkable surge by virtually any modern-day metric. It is also likely that the 9.5 per cent rate understates the extent to which labour market conditions are deteriorating. Just witness the increasing number of companies asking employees to take unpaid leave. Meanwhile, after several years of decline, the labour participation rate has started to edge higher as people postpone their retirements and as challenging family finances force second earners to enter the job market.

Notwithstanding its recent surge, the unemployment rate is likely to rise even further, reaching 10 per cent by the end of this year and potentially going beyond that. Indeed, the rate may not peak until 2010, in the 10.5-11 per cent range; and it will likely stay there for a while given the lacklustre shift from inventory rebuilding to consumption, investment and exports.

Beyond the public sector hiring spree fuelled by the fiscal stimulus package, the post-bubble US economy faces considerable headwinds to sustainable job creation. It takes time to restructure an economy that became over-dependent on finance and leverage. Meanwhile, companies will use this period to shed less productive workers. This will disrupt consumption already reeling from a large negative wealth shock due to the precipitous decline in house prices. Consumption will be further undermined by uncertainties about wages.

This possibility of a very high and persistent unemployment rate is not, as yet, part of the mainstream deliberations. Instead, the persistent domination of a “mean reversion” mindset leads to excessive optimism regarding how quickly the rate will max out, and how fast it converges back to the 5 per cent level for the Nairu (non-accelerating inflation rate of unemployment).

The US faces a material probability of both a higher Nairu (in the 7 per cent range) and, relative to recent history, a much slower convergence of the actual unemployment rate to this new level. This paradigm shift will complicate an already complex challenge facing policymakers. They will have to recalibrate fiscal and monetary stimulus to recognise the fact that “temporary and targeted” stimulus will be less potent than anticipated. But the inclination to increase the dose of stimulus will be tempered by the fact that, as the fiscal picture deteriorates rapidly, the economy is less able to rely on future growth to counter the risk of a debt trap.

Politics will add to the policy complications. The combination of stubbornly high unemployment and growing government debt will not play well. The rest of the world should also worry. Persistently high unemployment fuels protectionist tendencies. Think of this as yet another illustration of the fact that the US economy is on a bumpy journey to a new normal. The longer this reality is denied, the greater will be the cost to society of restoring economic stability.

The really bad news still continue...

Job losses (unemployment figures) arguably are the most important variable when it comes to evaluating whether economies are recovering from the economic recession. Despite evidence of many "green shoots" job losses in the U.S. continues to mount with the latest figures shocking investors.

Financial Times reported as follows:

The US economy shed another 467,000 jobs last month, signalling aggressive government stimulus measures are failing to unshackle the labour force from the grips of the recession.

The result was worse than economists expected and pushed the unemployment rate from 9.4 per cent to 9.5 per cent, a 26-year high. Thursday’s figure shows further erosion from the previous month’s decline of a revised 322,000 drop.

“If you were banking on the US driving a vigorous recovery, think again,” said Alan Ruskin, a strategist at RBS Greenwich Capital. “The employment report can largely be taken at face value, and the face value story is a labour market that is not improving nearly as rapidly as the May data suggested.”

Since the recession began in December 2007, 6.5m jobs have been lost and the unemployment rate has climbed by 4.6 percentage points. Although the US has shed jobs in each of the last 18 months, the June losses still mark an improvement from the first three months of the year when an average of 691,000 jobs per month were lost.

The job losses reported by the labour department on Thursday were widespread across industries with manufacturing, business services and construction.

A mix of recent data during the last month has raised hopes that the US is due for a recovery from the worst recession in the last 50 years. However the timing or shape of that recovery remains muddled as people and companies deal with unprecedented uncertainty and fears over unemployment continue to crimp demand.

Manufacturing and housing have shown some signs of life amid a strong stock market rally in the first quarter, but consumer confidence continues to face headwinds and construction spending is sputtering.