From Recession to Recovery: How Soon and How Strong?

19-May-2009

From Recession to Recovery: How Soon and How Strong?

To say we live in interesting economic times is a considerable understatement at the present time. A year ago, who would have thought it possible that:

  • The world economy was likely to contract by around 1% in 2009 - the first fall in global GDP since World War II;
  • 28 of the top 30 developed economies would be in recession, with the US and UK economies likely to shrink 3%, Japan and Singapore by 6% and Germany by 4.5%;
  • Share markets would fall nearly 50% from their peaks (of late 2007);
  • The RBA would cut interest rates by 4.25 percentage points in eight months;
  • US car sales would drop by over 40% year over year;
  • Exports from many Asian countries would drop by 20-40% yoy;
  • The US unemployment rate would rise from 5% in April 2008 to 8.9% in April 2009;
  • Governments around the world would be required to rescue banks on a very large scale and the availability of finance would quickly replace labour shortages as a key constraint on business performance;
  • The A$ would fall from US$0.98 in July 2008 to a low of around US$0.60;
  • Oil prices would drop from nearly $150 per barrel in July 2008 to a low of around $35 a barrel; and
  • All of the above could happen within the space of a year!

I could provide countless other equally breath-taking and virtually unprecedented statistics to impressively fill any awkward breaks in dinner party conversations, but you get the picture. The world is in the middle of the largest economic recession that any of us will have experienced in our working lives and are likely to ever experience.

The IMF has just published an excellent article in its April 2009 World Economic Outlook entitled “From Recession to Recovery: How Soon and How Strong?” Here’s the link for those who would like to read it in full.

For me, the key conclusions of the IMF’s analysis were:

  • The IMF has analysed all the recessions of the past 50 years (interestingly, the statistics do not include the Great Depression period, however, to be fair, the Fund does examine the parallels between then and now separately in the article)
  • For all recessions over the past fifty years, the average recession (defined as the fall in GDP from peak to trough) lasted around 3.5 quarters, the subsequent recovery period (the time taken to (re)achieve the prior peak level of output) took slightly less time (averaging just over 3 quarters) and the average decline in GDP was around 2.7%.
  • Recessions that involved financial crises, not surprisingly, were substantially worse than the average recession, with an average length of over 5 and a half quarters (i.e. nearly 18 months of declining output), and a similarly extended period until the previous GDP peak was (re)achieved (5.6 quarters). The loss in output was a larger 3.4% on average and perhaps more importantly the rate of recovery in the first year of recovery, was much slower than that of the average recession (2.2% on average compared to 4% for all recessions)
  • Recessions that were highly synchronous across the globe (i.e. involving many countries simultaneously) were also worse than the average recession (lasting 4.5 quarters i.e. around an extra three months, taking 4 quarters to (re)achieve the previous peak, i.e. an extra quarter also, and on average recording a GDP decline of nearly 3.5% i.e. worse than a normal recession and about as bad as a recession involving a financial crisis). Recovery in the first year for synchronous downturns, however, was stronger than for recessions involving financial crises (+3.7% vs. +2.2%)
  • However, recessions that involved both a financial crisis AND were highly synchronous, as is the current situation, were another matter altogether. While relatively rare over the past 50 years (just 6 recessions out of the sample of 122 recessions studied - Finland, France, Germany, Greece, Italy and Sweden), the recession phase of falling GDP lasted over 7 quarters, the recovery phase to (re)achieve the previous peak took almost as long (6.75 quarters) i.e. together 14 quarters or nearly four years on average, GDP on average fell nearly 5% from peak to trough and in the first year of recovery, GDP recovered only relatively slowly by 2.8% (this is slightly stronger than for a recession only involving a financial crisis as one might suspect). This leads the IMF to conclude that the current recession is likely to be unusually long and severe and the recovery sluggish.

Other interesting perspectives of the analysis were:

  • Usually monetary policy is very effective in shortening recessions, except in the case of recessions involving financial crises, when problems in the financial system (e.g. risk aversion to new lending by banks) make interest rate policy less effective than normal
  • Fiscal policy turns out to be much more effective in recessions involving financial crises - however, its effectiveness is a decreasing function of the level of public debt (i.e. the more debt a government has before the crisis, the less credible fiscal responses are, presumably because markets and investors have concerns about the possibility of the government defaulting)
     
  • Part of the reason synchronised recessions are longer and deeper than normal recessions is that exports play a much more limited role in recovery than normal (as all countries’ demand and exports drop simultaneously)
     
  • Part of the reason why recoveries from financial crises are slower than from normal recessions is that typically savings rates rise substantially (this has been the case in the early part of this recession globally and is likely to be continued given negative saving rates in recent years and the large reduction in wealth as a result of stock market declines). The flow on implication is that consumer spending is slower to recover than otherwise would be the case. This has implications for the forecast rate of growth and capital spending that should be pencilled in coming out of the current recession.
     
  • The US has often been at the centre of synchronous recessions (and it is again) - that's why I spend so much time looking at US indicators over Australian indicators. It is likely to be broadly the case that the world economy and the Australian economy will not recover before the US economy does.
  • In terms of the parallels between the current period and the Great Depression (note a depression is typically defined as a period where GDP falls by 10% from peak to trough), there are a number of similarities (the US is the epicentre of the shock, the bust was preceded by a credit boom, liquidity and funding problems with banks), though on the positive side inflation has not yet become deflation, there has been a globally coordinated and concerted policy response (this was not the case in the early 1930s), there have been few runs on banks and protection has not yet reared its ugly head on a broad scale.

Before I turn to the conclusions we should draw from this article for our businesses, I’d like to address the issue that the article is mainly about global developments and perhaps not necessarily as relevant to Australia, though I suspect the Government’s recent admission that Australia is also in recession and the recent sharp rise in unemployment are sufficient proof. Long experience has taught me that it is critical to follow developments in the US economy above all others in terms of assessing the risk of a recession in Australia. This lesson has hopefully been learnt (or in some cases re-learnt) by the proponents of de-coupling in recent years. This is not to say that economies cannot have their own cycles, however, history tells us that the Australian economy (and the rest of the world) typically suffers recessions when the US economy recesses (in large part because the US economy remains the largest in the world, but increasingly as globalisation increases linkages between economies and financial markets).

The following chart reinforces the point, with the Australian business cycle closely following the US business cycle over many years, with only the technology recession in the early 2000s proving the exception to the rule.

To date, the Australian economy has not experienced the full extent of the global recession, due to a combination of the extended tail of the prior resources boom, rapid policy action by the RBA and the Federal Government – the latter via two stimulus packages for consumer spending, an expansionary 2009-10 Budget focused on infrastructure spending, the weaker A$ and a generally more robust financial sector. However as the following charts show:

(i) unemployment is now beginning to rise more sharply;

(ii) leading indicators of unemployment such as ANZ’s newspaper job advertising series warn that the unemployment rate is going to rise extremely sharply in the months immediately ahead notwithstanding March’s surprise (and I believe very temporary) dip; and

(iii) the significant divergence between the Westpac Melbourne Institute’s leading indicator series (-5.1% yoy) and the same institutions’ coincident indicator series reminds that the prospects for future economic activity in Australia are considerably weaker than current conditions, with the latter currently boosted by the Government’s stimulus packages.

What conclusions can we draw for our businesses and what actions can we take?

Firstly, I’d be preparing most businesses for a few very tough years and conducting stress tests and scenario planning under extremely pessimistic assumptions as survival is key. That way, hopefully the surprises will be on the upside.

Secondly, note the good ideas of other companies – e.g. in reducing labour costs through job sharing, four day weeks or nine day fortnights, voluntary or compulsory leave without pay and/or pay reductions. But be alert to the parts of your business that perform better than expected in the current conditions and seek to understand what’s driving their outperformance.

Above all, remember, the cycle lives on. Even if this is the worst recession since the Great Depression (or even another depression), opportunities will arise as competitors fail or new markets are revealed. And recovery will eventually occur, even though I believe that remains somewhat further away than most commentators, notwithstanding signs of recent improvement in a number of key indicators globally. The key elements/indicators to be watching for signs of impending recovery include:

  • a resolution of global banking sector problems;
  • an improvement in residential and commercial real estate approvals in the US (and Australia);
  • improved business confidence; and
  • improvement in share prices (especially financial share prices).*

But that’s another article.

Ivan Colhoun is Streamwise's economic consultant and can be contacted at ivan.colhoun@bigpond.com.

* The above list draws heavily on excellent work on leading economic indicators by Kieran Davies, the Chief Economist for Australia of Royal Bank of Scotland.

 



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