A Phantom Recovery?

NEW YORK - Where is the American and global economy headed? Last year, there were two sides to the debate. One camp argued that the recession in the United States would be V-shaped - short and shallow. It would last only eight months, like the two previous recessions of 1990-1991 and 2001, and the world would decouple from the US contraction.

Others, including me, argued that, given the excesses of private-sector leverage (in households, financial institutions, and corporate firms), this would be a U-shaped recession - long and deep. It would last about 24 months, and the world would not decouple from the US contraction.

Today, 20 months into the US recession - a recession that became global in the summer of 2008 with a massive re-coupling - the V-shaped decoupling view is out the window. This is the worst US and global recession in 60 years. If the US recession were - as most likely - to be over at the end of the year, as is likely, it will have been three times as long and about fives times as deep - in term of the cumulative decline in output - as the previous two.

Today's consensus among economists is that the recession is already over, that the US and global economy will rapidly return to growth, and that there is no risk of a relapse. Unfortunately, this new consensus could be as wrong now as the defenders of the V-shaped scenario were for the past three years.

Data from the US - rising unemployment, falling household consumption, still declining industrial production, and a weak housing market - suggest that America's recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close but it has not yet been reached. Most emerging economies may be returning to growth, but they are performing well below their potential.

Moreover, for a number of reasons, growth in the advanced economies is likely to remain anemic and well below trend for at least a couple of years.

The first reason is likely to create a long-term drag on growth: households need to deleverage and save more, which will constrain consumption for years.

Second, the financial system - both banks and non-bank institutions - is severely damaged. Lack of robust credit growth will hamper private consumption and investment spending.

Third, the corporate sector faces a glut of capacity, and a weak recovery of profitability is likely if growth is anemic and deflationary pressures still persist. As a result, businesses are not likely to increase capital spending.

Fourth, the re-leveraging of the public sector through large fiscal deficits and debt accumulation risks crowding out a recovery in private-sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth.

Domestic private demand, especially consumption, is now weak or falling in over-spending countries (the US, the United Kingdom, Spain, Ireland, Australia, New Zealand, etc.), while not increasing fast enough in over-saving countries (China, Asia, Germany, Japan, etc.) to compensate for the reduction in these countries' net exports. Thus, there is a global slackening of aggregate demand relative to the glut of supply capacity, which will impede a robust global economic recovery.

There are also now two reasons to fear a double-dip recession. First, the exit strategy from monetary and fiscal easing could be botched, because policymakers are damned if they do and damned if they don't. If they take their fiscal deficits (and a potential monetization of these deficits) seriously and raise taxes, reduce spending, and mop up excess liquidity, they could undermine the already weak recovery.

But if they maintain large budget deficits and continue to monetize them, at some point - after the current deflationary forces become more subdued - bond markets will revolt. At this point, inflationary expectations will increase, long-term government bond yields will rise, and the recovery will be crowded out.

A second reason to fear a double-dip recession concerns the fact that oil, energy, and food prices may be rising faster than economic fundamentals warrant, and could be driven higher by the wall of liquidity chasing assets, as well as by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created a major income shock for the US, Europe, Japan, China, India, and other oil-importing economies. The global economy, barely rising from its knees, could not withstand the contractionary shock if similar speculative forces were to drive oil rapidly towards $100 a barrel.

So the end of this severe global recession will be closer at the end of this year than it is now, the recovery will be anemic rather than robust in advanced economies, and there is a rising risk of a double-dip recession. The recent market rallies in stocks, commodities, and credit may have gotten ahead of the improvement in the real economy. If so, a correction cannot be too far behind.

Copyright: Project Syndicate, 2009.