By Martin Hutchinson
Money Morning/The Money Map Report
Right now, the conventional wisdom seems to be that the United States is looking at a "U-shaped" recession and recovery. Output declined gently in the third quarter, is dropping sharply now and will continue dropping sharply in the first and possibly the second quarter of the New Year, finally bottoming out and beginning a slow recovery thereafter.
That's the natural pattern that most recessions follow. However, this has been a pretty unnatural recession, with a number of highly artificial actions undertaken to fight it, meaning we must plan for the possibility that it won't be a "U" pattern, but will instead follow a less-frequently seen pattern.
When you think about it, the alphabet presents a number of fun shapes, patterns or trajectories that an economic cycle might follow. There's a slightly slanting J – a shallow downturn followed by an energetic, near-vertical upswing. There's an L – a descent into the recessionary pit, followed by a total refusal to recover – kind of like an accident victim who flat lines on the way to the emergency room. There's an O, round and round in circles, never going anywhere – you can think of that as being the typical pre-industry economy, without significant technological change.
When the Roman Empire collapses or the Industrial Revolution happens, you get a (possibly upside-down) Q, in which the economy escapes from the static O, to move down or up in the Q's tiny tail. There's an R – round in circles for a time, followed by a sharp descent into the economic mire: That's static – albeit cyclical – economy, where some environmental disaster hits, causing output to tank.
There's both the U and the V – the latter being an economic cycle where a slump is immediately followed by a sharp rebound, with no period of depressed activity at the bottom.
And of course there's the W, the classic "double-dip" recession, like the one the United States experienced in 1979-82. W-shaped recessions can be further divided into two types: There's the "lazy W," in which the second downturn is worse than the first; and there's the "energetic W," in which a deep recession is followed by a shallower one that is barely a blip in a strong recovery.
The recession of 1979-82 was a slightly lazy W, whereas the 1929-41 Depression-era downturn can be thought of as a very deep energetic W, in which the second dip (1937-38) was still part of the same overall economic event, but was much shallower than the first.
Had the United States been on a gold standard with an administration determined to maintain budget discipline, the current unpleasantness – which started with a major banking crisis – would probably have followed a V-shaped trajectory. The banking crisis would have caused output to descend rapidly to a considerable depth. But once a bottom was reached, the U.S. economy would have recovered almost immediately, showing a period of extra-rapid growth as output returned to a normal trajectory.
That's how it worked in pre-Keynesian gold standard days, when governments and business followed the downturn advice of onetime U.S. Treasury Secretary Andrew Mellon, who said it was wise to "liquidate everything." The economy might descend to an unpleasant depth, but once it turned, the forces that would fuel the recovery were very strong. Thus, the recoveries after the recessions of 1893-96 and 1920-21 were both exceptionally vigorous by modern standards.
Most modern recessions are U-shaped, rather than V-shaped. When a recession hits, governments run budget deficits while central banks lower interest rates and allow the money supply to expand. That limits the depth of the downturn, but it also reduces the speed of the recovery, since the natural stimulus from a smaller downturn is weaker, while the government stimulus wears off after a while. That's what we got in 1991 and 2001; in the latter case, the U.S. government stimulus, both monetary and fiscal, was very strong indeed, so the recession was extremely shallow, but recovery was exceptionally slow.
In 1979-82, we had a W-shaped recession. The first leg was caused primarily by U.S. Federal Reserve Chairman Paul A. Volcker's now-famous attack on inflation, in which he boosted interest rates well above their normal level, and choked off economic activity. That caused the first dip, which was ended by monetary relaxation. However, monetary policy was tightened again in late 1980, so we got a second dip, which was not balanced by the usual fiscal stimulus, and so proved to be quite deep. Being deep, the second half of the W was followed by a strong recovery from 1983.
This time around, both the initial banking crisis and the fiscal and monetary stimuli have been exceptionally strong. That raises the possibility of a W-shaped double-dip recession. Initially, the stimulus may act like a shot of adrenalin, causing the downturn to abort and be succeeded by what seems like recovery. However, the stimulus must inevitably be temporary, and will produce both extra-rapid money supply growth and an extra-deep budget deficit. That is likely to lead to a second downward leg, this time accompanied by unpleasant inflation, as the "hangover" from the excessive stimulus is felt.
Even more unpleasantly, we could see an L shape – "Bloody L," if you'll allow me to use a British Cockney phrase, reflecting the unpleasantness of the outcome. That would result in a situation in which the ultra-low interest rates left in place too long fuel inflation, while out-of-control public spending produces deficits that permanently dampen growth, so recovery never really arrives at all.
That can happen: Japan in the 1990s had an L-shaped economic downturn, although with zero growth rather than a prolonged recession. More ominously, Argentina after 1945 transitioned quite quickly from a rapidly growing, buoyant economy into a global basket case, with occasional bursts of hyperinflation. That's the worst-case scenario for the United States. It's not likely, but neither is it impossible.
So what are we most likely to see? The factors causing short-term strength are currently powerful. The collapse in oil prices has caused retail sales to be considerably less weak than expected, stronger consumer confidence and leading indicators both point to an approaching economic bottom, and the stock market is up more than 10% from its November low.
Instead of a "worst" down quarter, the first half of 2009 may see a period of unexpected strength, with cheap mortgage money producing an apparent bottom in the housing market, a bottoming out and initial recovery in U.S. gross domestic product (GDP), and an additional bounce in U.S. stock prices.
Don't be fooled if this happens (though by all means try and make a buck or two out of the short-term stock market bounce). The Obama "stimulus package" and massive federal government slush funds will exact a price – in the second and probably deeper leg of a lengthy lazy W recession – the much-feared "double-dip" downturn.
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- Money Morning Special Report (Part II of II):
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Paul A. Volcker.