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Saturday, July 3, 2010

Is a double-dip recession likely?

Short answer, I think, is no. It is extraordinarily difficult to think about what the impetus for that would actually be. There is certainly not an overabundance of inventories as evidenced by very low, actually historically low, inventory to sales ratios. There won't be an interest rate shock anytime soon as deflationary tendencies continue to keep the need for interest rate increases down. In fact, the plunge in long-term bond rates we have seen recently will, if sustained, prove stimulative to the housing sector.

A major economic shock elsewhere in the world is similarly unlikely to cause a recession. As I have mentioned previously, the United States is not a major exporter in proportion to its GDP. Even a 30% decline in exports to China would represent a $21 billion hit to output. If Europe absolutely cratered all at once, we might lose a percent of GDP or so. It is actually difficult to think of a time when the United States has fallen into recession due to a major financial panic elsewhere in the world in the last 100 years. In the 19th century, financial market panics in Europe did have deleterious effects here, but you would be hard pressed to find one since. The one possible exception is if Europe sustained a series of sovereign defaults and its banks absolutely buckled without assistance from the ECB or member states. It is possible to conceive of a financial contagion effect under those circumstances could cause a renewed financial crisis here. If that were to happen, a recession would be likely.

Now, then, what do the recent data suggest? This is confusing as all hell (technical term there). Jobless claims remain elevated even though these levels don't make sense given what else we know. Consumer spending, after some strong months earlier this year, seems to be flat in the most recent months. Job creation as measured by the private sector job gains has decelerated from a few good months earlier. Manufacturing still appears strong, though might be slowing now that the inventory cycle is complete (a phenomenon that we noted here earlier). All of this suggests that growth will be slow over at least the next six months. The stock market's last 5-6% sell-off I think is a reflection in this re-evaluation of conditions. One cause of this may well be that money supply has been flat for some time as the Fed has attempted to ease off some of its earlier stimulus. It has also withdrawn itself from several of the emergency programs. A tightening of money supply usually has a powerful effect and that may well be at work here.

Part of the Fed's quandary is that it did increase money supply rapidly in response to the recession and it has been nervous about a potential outbreak of inflation some time down the road. As such, when the data were more positive, they began to step off the pedal a little bit. However, the transmission mechanisms for money supply (namely the banking system and related credit markets) remain entirely broken or at least gummed up. We can see this in the absolute collapse of the velocity of money (sorry, Monetarists, this is an empirical fact that the velocity of money is not a constant). As such, the outlook for inflation is very benign. In fact, it is so benign that I think we are seeing the effects of deflationary expectations beginning to take root, particularly on the part of businesses.

One distinct possibility as a result of the fundamental deflationary tendencies in the global economy is that, led by the needless European austerity measures, we could enter a very protracted period of low growth. The principal cause of this is that nominal debt burdens still remain high and without nominal wage increases these burdens are very difficult to pay down. As such, consumer spending is going to be kept under wraps in a deflationary environment.

In this sort of environment, bonds and cash do look more attractive than they otherwise would at present interest rates. Stock prices are based off of nominal profits and those are harder to come by in an environment of non-existent inflation and weak pricing power. I have to confess that I did not expect that the European governments would so rapidly enact such massive anti-stimulus as they have, but alas, it is here.

Hopefully, the central banks will realize what the larger threat is and become far more dovish on inflation than they have been. If one is truly worried about a sovereign debt problem, the answer is higher inflation, not deflation.

In any case, recent events should give one some pause as the rate of deterioration in growth was more rapid than one could reasonably expect. A double-dip recession is unlikely (as James Hamilton at Econbrowser points out), but there is a distinct possibility that we enter a prolonged period of lackluster growth due to policy making errors in Europe and, to a much lesser extent, here.

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