The Hindu Business Line : US recession: Prolonged and painful?

The current recession is likely to be more severe than what was experienced in the 1970s and early 1980s. It can last longer than six quarters and the US may not return to the trend growth rate before 2011 or 2012, says ISHWAR HEGDE.

It is official now. The US is in severe recession. It is already bad, and may get worse in 2009. Does it mean that the Great Depression of 1930s is revisiting us or is it just another version of the recessions of 1973 and early 1980s? What is clear is that it is fast morphing into a mammoth global economic crisis. How long is it going to last? And how painful would it be? May be economic history has some answers.

Economic and business cycles are nothing new for any economy. Historically, bust is a natural and ultimate outcome of a boom. A recent study by IMF on ‘What happens during recessions?’ offers an interesting perspective on the issue.

Looking back

Over the period 1960-2007, a typical advanced country witnessed about six recessions — one every eight years. While some were mild, and hence a quicker recovery, others were severe and took longer to recoup. Recessions on an average lasted for about four quarters. An important observation was that a recession is prolonged and painful if it is accompanied by housing price busts or credit crunch or both. Such recession invariably causes far-reaching economic consequences.

The US economy has experienced seven recessions during 1960-2006. None had the element of severe bust in housing or credit crunch. Only two of these were severe — one during the oil price shock in 1973 and the other during the early 1980s. Both were outcomes of inflationary shocks, the latter was also combined with high interest rates.

However, the economic losses in terms of consumption, investment, employment and income during these two recessions were no match to what happened during the Great Depression of 1929-1933. The crisis in 2001 would have been another severe recession, but the Federal Reserve effectively postponed it to what we are facing today.

The bust of the housing bubble in 2007 was the genesis of the current US crisis. The accommodating policy of the Fed and widespread wealth psychosis among US households and financial players were responsible for promoting the housing bubble during 2002-06. The excessive mortgage exposure took the sub-prime loans to unheard of levels and eventual collapse of the financial system in 2008. This has now morphed into a severe economic recession not only for the US, but for the world.

Comparative study

It would be worthwhile to see where the impact of the current recession stands vis-À-vis the previous ones and what the indications for the future are. Three major observations in this regard are:

First, the current recession is a confluence of all possible shocks; a housing bust coinciding with a severe credit crunch and a sharp equity bust, topped by inflationary shocks. Never before in the US history do we find such a queer confluence of all possible shocks.

Second, its economic impact, particularly on leading indicators, is so far much sharper than what was typically observed in the past two severe recessions, but milder than what was observed during the Depression (Table). Housing prices have already corrected by about 22 per cent and the slide is continuing. The residential investment has halved from the peak of March 2006. The equity prices have corrected by over 50 per cent and are still falling. To top it all, credit crunch and contraction levels are unprecedented. This is only the beginning and it is yet to be known when and where the current trends bottom out.

Third, unemployment rate, which is a key recession indicator, has so far risen to 6.7 per cent, which is high in terms of absolute numbers.

Non-farm payrolls plummeted by 533,000 in November 2008, the worst decline since 1974, thereby taking the number of jobless to 1.9 million this year.

The broad comparison conclusively establishes that the current recession is likely to be prolonged and painful than what was experienced during the 1970s and early 1980s. In other words, the recession can last longer than six quarters and the total economic and wealth loss might be huge. Our recovery chart, based on simulations, shows that the US may not return to the trend growth rate before 2011 or 2012 (Graph).

Differentiating factors

However, it is unlikely that it could be as bad as the Great Depression in terms of leading economic indicators.

Unemployment rate is a key differentiator. While most predictions suggest that it may even reach 10 per cent this time, it is difficult to imagine unemployment rate touching 25 per cent as seen during the Great Depression. Another difference this time is the quick and active policy response from the Fed and the US government to contain the crisis. In contrast, these two kept feeding the crisis during first three years. It was only after Franklin Roosevelt’s “New Deal’ was put in place that the economy started recovering.

In fact, the recession was long due, as the up-cycle witnessed since 1991 was the longest one in the country’s history. The US has excessively leveraged its economic and currency power during this period, not only to sustain its growth, but also to survive the 2001 crisis. But in the process it has created a double whammy of a $450-billion fiscal deficit and $850-billion trade deficit.

No quick recovery

It is during this period, US households resorted to excessive spending and the banks to reckless lending. An average American’s debt is now over 140 per cent of his disposable income. Similarly, some financial players have leveraged their assets to over 50 times. The de-leveraging process is in progress to correct this structural imbalance, but it may take a much longer time. This exercise itself is going to make the recession prolonged and painful. In a nutshell, the economic history shows that the US economy has already been over-harvested and, hence, needs a fairly long time to replenish.

Can President-elect Barack Obama stop this recession from being prolonged and painful? Despite infusion of funds and guarantees worth over $2-3 trillion during the last three months, credit lines remain choked.

To achieve a quick recovery in the housing market and the US economy, restoration of normalcy in both credit and job markets are primary conditions.

While leaving the credit market to the Fed, Mr Obama’s challenge is to find ways to create massive income generating opportunities. He has spoken of the biggest infrastructure investment in the US despite spiralling budget deficit. These are extraordinary times and, therefore, need much aggressive, newer, dynamic and many versions of the “New Deal” from the US and other governments across the world to save the world economy from an impending disaster.

It is a Herculean task. Mr Obama, we hope, we can.

(The author is Chief Economist, Essar Steel. The views expressed are personal. blfeedback@thehindu.co.in)

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