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"U.S. economy like a patient after major operation"

This article was published in The Globe and Mail on September 7, 2010.
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Financial market skepticism has deepened in recent weeks about the sustainability of the U.S. recovery. Chatter about a possible double-dip recession has increased and some pundits have raised the spectre of a depression. Much of the negativity stems from the weak pace of economic growth, which has been less than half the pace of a traditional recovery cycle. Make no mistake, the United States did not experience a typical recession and it won't have a typical recovery. However, the comparison with traditional recessions and recoveries is wrong. The right historical context is to look at the experience of other major economies after a deep and widespread financial crisis.

In 2009, the International Monetary Fund issued a very useful analysis that looked at the duration and magnitude of recessions and recoveries among industrialized countries. It examined four aspects: the length of contraction; the peak-to-trough decline in real gross domestic product; the increase in GDP within the first year of recovery; and the length of time for GDP to return to pre-recession peak levels. The report provided the details of traditional business cycles and those after financial crisis and synchronous financial crisis (SFC).

The IMF found that a typical recession extends just over three quarters, while an SFC downturn - such as the one we have just experienced - generally lasts seven quarters. In terms of depth, the severity of a typical recession is a 2.6-per-cent peak-to-trough contraction, compared with a 4.8-per-cent contraction after an SFC.

Now, consider the recent U.S. experience. While officials have yet to rule on the its duration, the peak-to-trough change in U.S. real GDP from 2008 to 2009 was six quarters. A broader perspective, including a large cross-section of data, will need to be considered before the actual duration is established. But it's safe to say that the duration of the U.S. recession was between six and eight quarters. And, the peak-to-trough decline in real GDP was 4.1 per cent. So by these two counts, the U.S. downturn was typical given the financial problems that occurred.

How about the recovery? Again, the United States appears to be tracking the average historical experience. Within the first year of recovery, the IMF found that real GDP expands by an average of 2.8 per cent after an SFC - which is about 1.5 percentage points slower than a non-SFC episode. The U.S. economy expanded by exactly 2.8 per cent in the first year of the recovery.

What's more, recoveries that follow an SFC are protracted, taking seven quarters for the level of real GDP to return to the prior peak. At best, the United States is in the fifth quarter of the recovery cycle, and GDP is 1.3 per cent below the peak level. To match the mean historical experience, the economy would need to plod along at an average 2-per-cent annualized pace over the next three quarters, or 1.5 per cent over the next four quarters, to hit the historical marker. Either outcome seems quite plausible. While GDP will likely reach its prior peak in 2011, the U.S. will still need to make up for the growth that would have normally occurred since 2008. That could take several years. Research suggests the economy could face structural changes for four or five more years. It is a sad testament of the times that this outlook for meagre growth and low inflation can be considered optimistic.

Given that the United States is tracking the traditional post-SFC experience, why would one now assume the outlier of a double-dip or deflation? None of the countries in the IMF study experienced either event (in the case of Japan, its lost decade was the product of a domestic financial crisis, not a synchronized financial crisis).

Obviously, there is no guarantee that the U.S. will continue to match the historical trend, and the sample of SFC occurrences in the IMF study is small. Given the fragility of economy, it wouldn't take much to knock economic output into one or more quarters of decline. I put the odds at 1-in-3. If this were to occur, it would be the product of psychology. While some trigger would be required (such as renewed falling house prices), the necessary ingredient for contraction would be the fear that causes households and businesses to cut their spending. Increasing speculation about double dips and deflation runs the risk of becoming a self-fulfilling prophecy if it becomes too intense.

The simple reality is that major imbalances had developed before the U.S. downturn and the policy response has created its own set of complications. These imbalances must be unwound. Unfortunately, it takes time. The country is like a patient after a major operation; it's now in the process of healing. Policy makers, households, and businesses want the patient out of bed and life back to normal. It simply isn't possible. An extended period of convalescing is required. This will naturally lead to frustration and worries about whether progress is truly being made. It will provide fuel for the bears that will augur of terrible times to come. History, however, is not on their side.


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