Looking towards an economic recovery in the US

May 11 2009 - Risk aversion is declining and investors are feeling more comfortable about the outlook.  Of course, a depression-like outcome was always highly unlikely. But the uncertainty and associated fear factor was at such a high level that people were willing to believe in the possibility of awful scenarios.

 This is an unusual recession with characteristics that mark it as quite different from any experienced in the past.  Reasonably, it follows that one should also expect the recovery to have features that will distinguish it from previous economic rebounds.

 The crisis of the financial system, which is now easing, was the most severe since the nineteen thirties and has been experienced in every corner of the world.  And, of course, the relatively high degree of integration of the global economy has resulted in a synchronised recession that, according to the IMF, is the first one since the Second World War.  Little wonder, then, that the policy response has also been massive.

As expected, US officials have put a positive spin on the results of stress tests conducted on major banks.  The message is that the ships are not sinking, though in some cases there are holes to be plugged.  There is just enough information released to present the government’s analysis as being a reasonable one that does not stretch credibility.  Importantly, the market is buying it, and bank stocks have rallied.

 In the current context, building up trust and confidence in the banking system is an important objective.  So even if the tests were not as rigorous as many would have liked and the size of the hole below deck may turn out to be bigger than estimated, managing market psychology towards a positive view of the banking system is definitely beneficial for the economy.

 The banks are still reluctant to lend and have mounds of cash in the form of excess reserves at the central bank.  But there is also a positive story coming out of the Fed’s senior loan officer survey.  This shows that in the three months to April, banks had tightened their lending standards by less than in the previous six months.  At first sight, this may not look all that cheerful, but in fact it is another bottoming-out signal.

 Observers are also monitoring the US labour market for signs of a turnaround.  Everybody knows that this is a lagging economic indicator.  What they are looking for, are gradually diminishing job losses, and that’s what they saw in the latest report.  Mind you, the state of the labour market is still very poor and few people expect job losses to end until next year.

 The latest employment data show that the private sector continued to shed jobs.  But the picture was made a little brighter by government hiring, although that included a large number of purely temporary jobs related to conducting the upcoming population census.  In general, people are working fewer hours, accepting pay cuts, taking part-time instead of full-time jobs because they are hard to find, or dropping out of the labour force.  This does not presage a quick economic turnaround.

 High unemployment and stagnating salaries aren’t going to encourage households to spend more freely.  Furthermore, those who conduct surveys have found that a behavioural change towards thriftiness and a search for value is underway among American consumers in all income classes.

 The cautious approach may also characterise corporate behaviour.  Firms may be reluctant to increase hiring or expand capacity until they have a much clearer view of the outlook for sales.  A smart strategy would be to maintain core personnel and capability but to stay lean until faster economic growth is underway.  Keynesian animal spirits will be held in check.

 Banks are going to play it safe, given the state of their finances and the nasty experience of the past few years.  New regulations will also come into force and act as a constraint on all firms in the financial services sector.  However, it is too early to say how tight the regulations will be.  It is safe to bet that creative minds in places like Goldman Sachs are already plotting ways of getting around any constraints.

 Currently, some analysts assume that there is substantial excess capacity in the economy, with the implication that growth can be ramped up considerably without fear of inflationary consequences.  A contrary opinion is that the economy’s potential growth rate was overestimated in the past few years and the economy was actually growing close to or above capacity because of a boom created by easy credit.

 One can also advance the argument that as a result of the deep recession capacity has been reduced, even though currently there is a large output gap.  As a consequence, policymakers may misjudge the extent of overcapacity and aim for a higher growth rate than the economy can achieve without unleashing the danger of inflationary pressure building up.