The Shape of Recovery

The worst, it seems, is over. Latest economic data from Japan to Germany to the U.S. suggest that the worst recession since the Great Depression seems to be over. And emerging economies, drivers of the global growth, are once again showing signs of improving economic activity. The U.S. economy, after witnessing a whopping -6.4 percent decline in the first quarter of 2009, seems to have bottomed out. According to analyst forecasts, the U.S. economy is expected to register a growth of 2.2 percent in the third quarter of 2009 after witnessing an improved -1 percent growth in the second quarter of 2009. After growing at 6.1 percent in first quarter of 2009, the Chinese economy grew at 7.9 percent during second quarter of 2009.
The shape of the recovery, however, is far from clear. For the global economy to regain lost momentum, the U.S. economy has to show signs of revival. Though most of the global economic growth is derived from the emerging economies of China and India, among others, because of the structural linkages between the U.S. economy and the rest of the world, the shape of U.S. recovery still dictates the global economic picture.

An ideal situation would be a V-shaped recovery where the global economy rebounds rather immediately to pre-recession level. During the first quarter of 2009, when the crisis was in its peak, most of the economists discredited the idea of the V-Shaped recovery. Then pessimists were arguing about L-shaped recovery–the worst of all recoveries–where the economy, after falling sharply, fails to recover again for a long time to pre-recession level. However, when the equity markets around the world rallied impressively during the second half of 2009, the idea of V-shaped recovery again gained momentum. Currently, experts are divided about the shape of the recovery. Speaking in a recent conference, Nobel Laureate Paul Krugman argued that the U.S. economy will at best show a W-shaped recovery, where the economy revives briefly after a sharp drop to collapse again before a final revival. Krugman, a true Keynesian, argued that existing housing problems in the U.S. and rising unemployment will prevent it from a V-Shaped recovery.

And despite the improvement in the economic activities around major economies, investors also seem to be shaky about the shape of this recovery. After the major sell off in the Chinese stock market in the third week of August, major stock indices around the world posted sharp declines. Investors are having a hard time distinguishing between whether this is a true recovery or one-off revival due to huge stimulus packages from governments around the world to revive their respective economies. These are valid concerns and the picture might not be as rosy as recent performance of major indices around the world.

The U.S.—a consumer driven economy—is facing structural challenges. With more than 9 million-plus unemployed people, which is growing bigger month by month, consumer spending is bound to take a hit when the unemployment checks stop for most of the unemployed and the stimulus-effect wears off for economy in general. Moreover, for a change, the profligate Americans are starting to save again—the U.S. consumer savings rate rose from near zero percent in 2007 to 7 percent in July 2009. On the long run, a rising savings rate is good for the U.S. economy as they don’t have to rely on the Chinese to borrow; however, at this point when the U.S. economy needs a boost, reluctant spending from consumers could stall the growth revival. Moreover, the fact that current growth has come largely from public spending rather than private is a matter of concern. Sustaining the current tepid recovery requires the shift of spending avenue.

China—the world’s manufacturing hub—needs to re-orient its economy toward self sustenance. Compared with the U.S. and India where consumption accounts for over 70 percent of the Gross Domestic Product (GDP), Chinese consumption only accounts for 35 percent of its GDP. When its exports took a sudden dip after the economic crisis, the Chinese government announced a $580 billion stimulus programme to boost domestic consumption and prevent the economy from spiraling downwards.

The stimulus package has to a large extent helped China keep its economy growing at a healthy rate. The same could be said about the easy-lending policy of state-owned Chinese banks which has pushed growth higher but at the same time fueled an asset bubble. Hence investors are wary that unless domestic consumption rises permanently or exports gain momentum, the growth might slip in the next quarter as the effect of stimulus subsides from the economy.

A slowing Chinese economy coupled with an artificially-created asset bubble could be a recipe for another disaster. With a weak monsoon, India’s projected economic growth of 6 percent is in serious doubt. Moreover with food prices rising due to weak monsoon, inflation in India is bound to rise in coming months. All these scenarios signal a difficult road down the line. Though growth in major economies is expected to recover, the size of economic output of these countries after the crisis is still not clear, i.e. whether the output of major economies can swiftly reach pre-crisis levels or remain below it for a long time.

Writing in the forthcoming issue of Finance and Development, Oliver Blanchard, Chief Economist of the International Monetary Fund argues that after a financial crisis, on average, economic output does not go back to its old output trend but permanently remains below it.

Published on The Kathmandu Post on Aug 29 2009

Links & References:

http://www.ngcci.org/index.php?nav=resources&page=ecoglimpse&id=834