Regular readers will recall that I began forecasting a Western recession some months ago. That judgement is now becoming mainstream. Last night, Willem Buiter called an imminent European recession. From Alphaville:
Even with a leveraged EFSF, additional fiscal tightening and tighter financial conditions are likely to be sizeable drags for Euro Area growth. Taking this into account, we revise down our Euro Area 2012 GDP growth forecast from +0.6% to -0.2%, now expecting a mild recession to start in 4Q 2011.
And a couple of night’s ago, the always excellent Gerard Minack also made the recession call for both Europe and the United States. The entire video from Lateline Business is worth your time:
You will have noticed that both of these recession predictions are based upon the same premiss, that Western governments will retrench spending causing their economies to slump into recession.
However, the last two day’s of US economic data has been reasonable. Yesterday Durable Goods Orders were stable, if not spectacular. And today, there was a revision up in 2nd quarter GDP, as well as a big fall in Weekly Unemployment Claims (which is volatile and should be treated with caution) as well as, a fair result in the Kansas City Fed Index for manufacturing, suggesting Monday’s ISM result may be stable at around par.
So what gives?
As Minack says, and I’ve argued for some time, a US recession is likley to come from the 1.5% or so of fiscal spending cuts that are being haggled over by the US Joint Select Committee on Deficit Reduction or “Super Committee”. With GDP already weak, such cuts are ipso facto a recession. Buiter has essentially used a similar calculus in his call for Europe.
But, with the US private sector data chugging along OK, if weakly, what kind of recession is it when public sector retrenchment causes a fall in GDP, rather than the route into recession that has typified post war business cycles, a tightening of monetary policy leading to a private sector bust? Fed watcher Tim Duy has put forward the case recession in these circumstances is not guaranteed:
I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year. That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery. As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels. Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth. Recession or not, a tragedy by any measure.
I won’t claim to be an expert on the Japanese economy, but there are few points one can make from the general macro data. First, here’s the post-bust history of Japanese GDP:
And the same time-frame for the General Government Deficit:
The first observation is that other than a small tightening in 1997, which ran headlong into the Asian Financial Crisis, Japan never tightened fiscal spending until the post-millenium global boom was ripping along, so we can’t really look to Japan to understand if it’s possible for the private sector to keep growing through a public sector retrenchment that results in overall economic shrinkage.
The fact is, the accounting identities of sectoral balancing tell us that this is a very difficult act to achieve. If the public sector is shrinking, then either the private sector must be taking on greater amounts of debt or the external sector must be expanding for GDP to remain positive. With private sector debt stable and/or shrinking that only leaves exports to pick up the slack. For the US and Europe to simultaneoulsy boost exports to offset other growth drags is also very unlikely.
The end result is that US and European fiscal retrenchment will most likely result in public and private sector job losses. These job losses will suppress already falling consumer sentiment and spending. That will result in rising inventories. Which in turn triggers the age-old business cycle response of further job losses in production and an inventory cycle.
So, even though fiscal retrenchment is an atypical trigger for recession in post-war terms, my bet is it will still trigger a typical post-war business cycle, within the larger structural adjustment underway in the balance sheets of Western governments and households. Which makes me think that it will be a deeper hit to growth than Buiter is currently predicting.
