EconoMonitor

Nouriel Roubini's Global EconoMonitor

RGE’s Wednesday Note – No Chance of a V-Shaped Recovery

The curtain has opened on Act Two of our “Year of Two Halves”—RGE’s theme since the end of 2009—with the slowdown forecast for H2 2010 getting here a bit earlier than expected. Growth in Q2 2010 registered a very weak 1.6%, revised down from an original estimate of 2.4%—a sharp slowdown from the 3.7% of Q1. This implies much weaker growth in H1 than even bearish forecasters had expected. Moreover, most of the growth was driven by a temporary inventory adjustment; final sales grew a mediocre 1.1% in Q1 and 1.0% in Q2.

All the tailwinds of H1 will become headwinds in H2, a shift we examine in a recent RGE Analysis available exclusively to clients. As state and local governments keep retrenching and even the federal stimulus diminishes, the fiscal stimulus will turn into a fiscal drag that will be much more pronounced in 2011 and after some of the 2001-03 tax cuts expire. The base effects from the lousy economic activity figures of 2009 are gone, temporary census hiring is finished and tax incentives—cash for clunkers, the investment tax credit, the first-time homebuyer tax credit and cash for green appliances—have all expired after “stealing” demand and growth from the future.

As we argued in our North America Focus last week, a succession of data releases has induced a race to the bottom as other forecasters revise their estimates down to figures closer to ours. Personal consumption—70% of aggregate demand—seems off to a rocky start this quarter: Core retail sales for July showed the third decline in the last four months. In the week ending on August 21, same-store sales data released by ICSC-Goldman Sachs showed a fourth straight decline. With inventory restocking over, the investment outlook is equally bleak. Corporate sector capital expenditure, the only component of aggregate demand that grew robustly in H1, appears set to slow: The shipments and new orders indicators of the July durable goods report showed a decline across categories. Meanwhile, despite the return to marginally positive growth in Q2, investment in non-residential structures will remain anemic at best through H2, given the record-high vacancy rates in commercial real estate. As we expected, the housing sector is already in a double dip: Single-family starts fell by 4.2% m/m in July, the third consecutive month of decline, and both existing and new home sales touched their all-time lows. In summary, every component of aggregate demand—with the exception of net exports, which weighed on growth in Q2—appears set to offer a worse contribution to growth in Q3 than the previous quarter.

The truth is that we have not had much of a recovery in the first place, which might prevent the economy from falling enough to display what many would label a double dip—although we are now assigning a 40% probability to such an outcome. Weak economic growth and labor market conditions imply that the U.S. output gap keeps widening and the employment to population ratio will continue to fall. The anemic recovery and downward trend of inflation and inflation expectations are raising concerns that the economy could not only surprise to the downside but eventually stall. A growth rate of 1% or lower (now likely for H2 2010) is a severe growth recession, as potential growth is closer to 3%.

With growth nearly stalled, an unstable disequilibrium arises that is likely to tip the economy into a double-dip recession. The unemployment rate climbs, the budget deficit widens because of automatic stabilizers, home prices keep falling, bank losses are much larger and protectionist pressures come to a boil. Stock markets could sharply correct, and credit and interbank spreads could widen as risk aversion increases. A negative feedback loop between the real economy and the financial system could easily tip the economy into a formal double dip: The real economy reaches a near-stall speed and risky asset prices correct downward, leading to a negative wealth effect, a higher cost of capital and reduced business, consumer and investor confidence.

Given political and fiscal constraints and banks’ unwillingness to lend, we remain doubtful of the potential for policy to prevent a double dip. Even a new round of monetary and quantitative easing can provide limited stimulus. The real issue facing the U.S. is the need for balance sheet deleveraging and repair, and that will be a multi-year process. The U.S. must brace itself for a long period of below-potential growth.


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4 Responses to “RGE’s Wednesday Note – No Chance of a V-Shaped Recovery”

economicminorSeptember 2nd, 2010 at 12:41 pm

Thanks Professor ETAL,You write well about the aspects of the big picture but underlying that is the real economy. In that real economy are real people trying to run really small businesses. These are the true backbone of the economic system.. Not GS or GM or even GE. For everything GE does would still be done if GE were 50 smaller businesses and probably for less cost.Most businesses start as micro businesses. One or two people with an idea. Since I was little, the burdens placed upon micro start ups has grown dramatically. In fact it has grown so big it is smothering most micro businesses and many small ones too. All in the names of protecting us from ourselves or with some new ideal or fee to support some bureaucratic cause.Big business has always found ways to get around the rules. Even big small businesses can find ways to circumvent the rules but micro businesses much of the time get trapped in the endless catch 22 of licensing, accounting rules, zoning laws, etc.Today we have TBTF who not only got caught up in gambling and lost but that was after they bought their way to the gambling table. The government bailed them out with money that will ultimately have to come from the micro and small business community in higher fees, taxes and cost due to the new gaming of commodities.IMO why the Tea Party exists today is not because of the regulations and taxes on those at the top but because there has been a continued piling on of rules, license fees and regulations, taxes and other fees and costs at the bottom end of the economy to the point where micro and really small businesses are strangling. This is a totally unfair and out of balance system. And is failing.An economic system is only as strong as its base and the base has always been the micro to small businesses. Until many of the burdens are removed America’s place in the world will continue to decline along with the standard of living and the middle class. Cheap money does little good at this point because much of that cheap money is siphoned off by local and state government, it does no good to just make more of it available..This does not mean we should remove more regulations from the TBTF or almost TBTF. We don’t need to let the free market take care of pollution or abuse. The free market won’t stop the TBTF from monopolizing and strangling the system. We need the top to be controlled but we need the bottom to be turned free to be entrepreneurs and craftsmen.

PessimistSeptember 2nd, 2010 at 3:57 pm

I’m all for freedom and turning entrepreneurs and craftsman loose. But please help me understand how small businesses are going to employ people in the U.S. at middle-class wages while competing with global companies producing similar products in countries where labor is cheap. I don’t see how small business can succeed let alone re-establish prosperity and a middle class.

economicminorSeptember 2nd, 2010 at 10:55 pm

Lots of micro to small business people make a middle class incomes. The way to increase demand when big business has excess capacity is to increase external demand. The way to increase demand at home is to allow the growth of ideas. You can’t have everyone working for either the government or big business.Neither Bill Gates nor Steve Jobs started out big. McDonald’s started with one store front.The US has lost its way. The foundation of our economic system is not functioning properly. It can not be made better by putting a new roof on or creating more debt to be serviced. Reference; foundation is micro and small business, the roof is the TBTF.It would be wonderful if all big businesses were run by Henry Ford types but they aren’t. Growth doesn’t come from the top down, it comes from the bottom up.How do you envision demand returning? Do you see the US just going back to what it was doing before 2007? Where are the new jobs going to come from? A resumption of housing? Even the Ipod is made overseas.

ThinkerSeptember 9th, 2010 at 4:52 pm

I agree that a new round of quantitative and monetary easing can only provide limited stimulus, hence I would suggest a three pronged strategy to economic recovery which I have previously posted on other Web forums as well:Firstly, a housing stabilization program (where the government would receive first rights home equity in return for making part of the monthly mortgage payment for those facing foreclosure, with the government disposing of its share in 10-15 years by having the homeowner to either refinance or sell the home then). The current foreclosure rescue plans are too indirect, they involve some write offs on the part of the lender and also give away government money. Under my plan, there would be no government giveaways, the burden would be on the homeowner (by not building equity) and the banks possibly having to writeoff some mortgage balance in 10-15 years time. In return the homeowner gets to stay in his home for 10-15 years (as long as he or she does not default) and the bank to receive monthly mortgage payments for the same period of time. At the end of the period, the homeowner would either have to refinance his mortgage or sell his or her home and the government would get its money back with any remainder first going to the bank and then the homeowner. By reducing the number of homes being foreclosed, new housing construction employment will increase, housing prices stabilize and possibly even increase.Secondly, a temporary bank to lend to those borrowers who otherwise would be able to borrow during normal economic times, but can not now due to risk averse banks. By the bank hiring employees with commercial banking experience and deferring part of their compensation to be based on loan repayment, it would help ensure sound lending decisions. Also it would only accept loan applications that have been rejected by commercial banks to avoid competing with them. After economic recovery, the bank’s loan portfolio would be sold off to commercial banks and the temporary bank shut down.Thirdly, to a limited extent and depending on how the first two programs work out – a stimulus program. By the way, the first stimulus program is still expected to have an effect, there was a delay because stimulus work needs to be planned first to avoid waste. Check out the article “Stimulus Money Unspent as Economy Struggles” dated August 16, 2010 on the CBS News website for more info on unspent stimulus. The way to tell if there is too much stimulus is if the inflation rate rapidly starts increasing above 3% (what I consider to be normal inflation), in which case the stimulus program should be rolled back.The first two programs would be revenue/expenditure neutral (debt to be paid back by eventual revenues). My recommended goal is 5% unemployment and 3% inflation rate before the above programs are closed. Another way of looking at the economic situation, is that the money supply flowing through the economy should not cause either too much or too little inflation and unemployment.We seem to be close to a deflationary period hence the need for the above strategy.By the way, incurring debt is not bad in the short run if there is low inflation and the purpose is to reduce unemployment to more normal levels. There has been huge debt incurred since the Great Depression and the Second World War, and the American economy has still thrived. The American economy has a further advantage in that the U.S. dollar is widely accepted overseas, so that to a certain extent, excess local demand (created by stimulus spending, for example) can be satisfied by importing foreign products without sharply increasing U.S. inflation.For those advocating tax cuts, keep in mind that people may just hold on to their additional money or pay off debt, thereby not stimulating the economy and not reducing unemployment. Therefore, I believe my strategy is much better for economic recovery. As the economy moves to a new equilibrium (one that reduces the proportion based on real estate to one relying more on other industries), I believe my economic strategy will reduce the pain involved in the transition.