Don’t Plan on a Robust Recovery

Last Monday, Federal Reserve Vice Chairman Donald L. Kohn spoke at the Hutchinson Lecture in Newark, Delaware. (See Federal Reserve website for full text) He talked about the current economic outlook and described a possible scenario for the recovery from the current recession. He was surprisingly candid about the possibility that we may experience a historically slow recovery.

Speaking about the historical pattern of robust recoveries after recessions, he said: “…. the last two business cycles cast some doubt on that conclusion. The recovery that followed the recession in the early 1990s was fairly sluggish. And with a lackluster recovery after the 2001 recession, the evidence supporting rapid bouncebacks after downturns was weakened further. Some analysts have suggested that those slow recoveries reflected the shallowness of the downturns--indeed, the research on the pre-1990 episodes indicated that the strength of recoveries was correlated with the depth of the preceding recessions, and the slowness of the recoveries from the 1990 and 2001 recessions would be consistent with that correlation.”

In its over-simplified form, the current recession is a reflection that an imbalance has emerged between supply and demand in the economy. The US economy has experienced a rather sudden and sharp decline in demand for housing and for cars. The decline in demand was so rapid that supply failed to decline fast enough to keep pace. Thus, the supply of houses and new cars far exceeded the demand. The resulting decline in prices has motivated the housing and automobile industries to sharply reduce the supply. The way that supply is reduced is to idle factories and lay off workers.

The short version is that the decline in demand for houses and cars has now spread to nearly every aspect of consumption in the country. The result is a very broad-based decline in demand throughout the economy, with producers aggressively cutting supply to try to keep up with the decline in demand. Prices will continue to decline until the relationship between supply and demand is restored to some level of balance. Meanwhile, the prospect of falling prices creates the possibility of what is called deflation.

In a deflationary environment prices tend to fall. Falling prices are very difficult to manage in capitalist economies like we and most of the developed world currently have. There are two ways to stabilize prices during a period of deflation: either by reducing supply, or by increasing demand. As already mentioned, reducing supply involves laying off workers and increasing the unemployment rate. Reducing supply (thus raising unemployment) is clearly not something that elected officials will do voluntarily (or at least publicly). Therefore the only political solution is to raise demand – which is the current game plan of the Federal Reserve and the Obama Administration. It was also the game plan of the Bush Administration.

Raising demand involves motivating consumers and businesses to buy things they would not otherwise buy. This plan involves motivating banks to continue to lend to businesses and consumers in order to renew the level of demand that existed before the economy went into this recession.

The government’s plan is to increase demand. Thus far it has proven surprisingly ineffective. In fact, the national decline in aggregate demand continues at near-record levels – even after unprecedented levels of government intervention. This continued decline in demand is driving further drops in supply as companies in nearly every industry are laying off workers in record numbers. Even with all this, aggregate demand is still dropping at a dangerous rate.

The recovery will not occur until demand stops falling. That’s why there is so much talk about finding “the bottom” of this recession. But the recovery will not occur until demand begins to rise. The strength of the recovery will depend on the timing and the rate of increase in demand.

What Vice Chairman Kohn said on Monday is that there are good reasons to believe that even once demand begins to grow again, the growth rate will be subdued.

Much of our excessive demand was based on excessive borrowing. It is not likely that consumers will quickly return to their over-consuming ways. In fact, the current trend is clearly toward increased savings. That means reduced demand. It is likely that total consumer borrowing will stop growing and it may actually start declining as consumers de-leverage. In this case, the extra demand that was fueled by new debt will cease. That could be as much as 20-30% of our economy. This happens to be an interesting number because it is in the ball-park of the decline in output during the great depression of the 1930’s.

At some point the government will be forced to deal with the effects of declining supply rather than focusing money and effort at trying to revive an artificially high level of demand.

In a twisted irony of modern politics, the government is essentially telling the people, “If you won’t borrow more money to buy more goods and services to revive the economy, then the government will do it for you – whether you need the goods and services or not.” I wonder how long it will take to come to the realization that that won’t work over the long term?