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.