Wednesday, September 17, 2014

Why The Economic Recovery Has Been So Slow

Many market watchers continue to express surprise over the modest pace of recovery in the US economy since 2009. Are they right to expect growth to have been more robust?

The short answer is no.

The 2008 recession is not comparable to other downturns since the end of World War II. Therefore, expecting the recovery to track the pace of prior recoveries is misguided.

With few exceptions, post-war recessions have primarily been led by inflation and monetary tightening. Some of these came as a result of war: the Korean War in the 1950s and the Vietnam War in the 1960s, when government spending contributed to price hikes. In the 1970s and early 1980s, the primary cause for inflation were sharp spikes in the price of oil. To a lesser degree, that was also the case in 1990.

While 2000-02 is remembered now for the substantial fall in equity prices, the economic downturn was actually mild. The dot-com bubble had burst and then 9/11 took place. But GDP contracted by just 0.3% and unemployment peaked at just 6.3%. It was a stock market recession more than an economic recession.

The economic contraction in 2008 was nothing like any of these recessions. Inflation and monetary tightening had nothing to do with the recession: core CPI peaked at just 2.5%.

It was, instead, a financial crisis, comparable in recent US history only to the 1930s.

During the course of 2007 and 2008, US household wealth fell by 25%, equal to about $15 trillion dollars. To put that number in perspective, annual GDP in the US in 2008 was $14.8 trillion. Nothing close to this had happened in the prior 75 years. In fact, the annual change in household wealth had never been negative.

When wealth falls, consumption falls. Real final sales in the US was negative year over year for 6 consecutive quarters during 2008-09. In comparison, final sales actually grew 1% during the trough of the 2000-02 recession.

Housing is a direct and indirect contributor to consumption. New homes create jobs and appreciating homes increase wealth. In the wake of the dot-com bubble, the housing market inflated like never before. This was completely unlike prior economic cycles. Pulling supply forward created a demand vacuum when this bubble burst. A major engine for the economy was damaged, the tail effects of which are still being felt. More than 5 years later, new home sales are at the trough levels of prior recessions.

Along with the boom in housing came a boom in household debt. This leverage was in large part underwritten by inflating asset prices (and also rising incomes); when those prices collapsed, so did the ability to fund debt. The economic expansions in the prior 30 years were fueled by leverage. The current recovery has not had anything like that to propel faster growth. Leverage is lower now than it was 30 years ago.

Along with the collapse in housing and consumption came a collapse in employment two to three times more severe than prior recessions in the post-war era. This becomes a vicious cycle: lower demand leads to lower employment, leading to even lower demand. The dynamic is not unique to the current recovery but the damage inflicted in 2008 was orders of magnitude more severe.

Expansions prior to 2000 were also helped by favorable demographic trends. Women entering the workforce in greater numbers added significantly to household incomes and total employment. This was a virtuous cycle, with growing income, consumption and employment reinforcing each other. That began to change well in advance of 2008 and has not improved since. Some of this (estimated to be about half) is related retiring baby boomers.

Government spending and employment had also been favorable during prior expansions. That was especially true in the 1950s, 60s, 70s and 80s. But since 2008, shrinking government employment has  impeded consumption and therefore the recovery as well.

The nature of the 2008 financial crisis makes the ensuing recovery different than every recovery in the post-war era. The losses to employment and wealth were far deeper than during inflation-driven recessions.  The use of debt and housing to speed recovery has been impaired by the 2007 bubble. Employment demographics and government spending have not been favorable, in contrast to prior recoveries. Add to this litany the fact that Europe, Japan and China are all growing more slowly now than previously.


None of this is news. The expansion during in the post-financial crisis era was expected to be weak. In fact, that is the pattern after every financial crisis. In comparison, the US's recovery has been remarkably quick (red line). Yes, the recovery has been slow, but it was expected to be worse.

From Calculated Risk: "When comparing the Great Recession against other advanced economies’ financial crises in recent decades, the current U.S. cycle has outperformed in terms of employment, even as most other measures of financial crises were just as bad — home prices, stock prices, GDP per capita, government debt and the like (post)."

Market watchers that expected a more robust recovery misunderstood the nature of the 2008 recession. Comparisons to other post-war recoveries are irrelevant. These are completely different animals.

So what happens next?

More than 5 years into the recovery, inflation remains below 2%. Employment is growing, but only slowly, also at about 2% per annum. Most measures of demand growth are positive, but modest. So the economy is expanding, but it's slow (post).

Today's Fed decision - to maintain rates low - is congruent with this slow recovery.

The corollary to the slow recovery is this: it's not unreasonable to expect the recovery to persist longer than average. The average economic recovery between 1919 and 1945 lasted 35 months; between 1945 and 2007, they lasted 57 months. This one has already lasted 62 months and there are few signs of the cycle topping.

The Fed has not even begun the process of raising rates yet, and probably will not for another year. If the economy reverts to one driven by the more typical inflation/monetary tightening cycle, then the recovery has many more months to run.  After the first rate hike,  the stock market is typically higher a year later.

The biggest threat is likely to come from equity prices. We will cover valuations in a separate post. For now, suffice it to say that equities are pricey relative to sales, earnings and balance sheets. But if 2000-02 is a model, then a fall in equity markets will be traumatic for investors but not so much for the general economy.

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