July 01, 2009
A V-shaped recession?
As James Morley has pointed out, often a sharp economic downturn is followed by an equally sharp economic recovery. One reason for that is the liquidation of inventories that accompanies any recession and restocking that takes place in recovery. What should we expect this time?
The graph below shows inventory investment as a percentage of U.S. GDP since 1947. There's been an improvement over time in inventory management, which I captured with a downward-sloping linear time trend. [Incidentally, this graph and many of the calculations that follow are constructed using the original nominal magnitudes. You can make mistakes looking at a number like the ratio of real inventory investment to real GDP since the respective deflators are different, whereas the ratio of two nominal magnitudes is always in correct natural real units, namely, percent of GDP.]
The typical pattern is for inventory investment to fall well below trend during an economic downturn. The cumulative drawdown of inventories since the current recession began in 2007:Q4 amounts to 0.58% of one year's GDP. The time trend suggests that, in the absence of a recession, we might have expected inventory investment to have been about 0.22% of GDP, and building inventories at that normal rate would have justified an increase in inventories over the last 6 quarters whose value would amount to 1.5 x 0.22 = 0.33% of one year's GDP. In other words, according to these calculations the level of inventories is lower than you would have expected in the absence of a recession by about 0.33 + 0.58 = 0.91% of one year's GDP. Add that restocking to the normal 0.21% inventory investment that we'd expect from the time trend as of 2009:Q3, and you get a possible contribution of inventory investment of 0.91 + 0.21 = 1.12% of GDP during the first year of the recovery.
If we are looking at the growth rate of real GDP, which is how we usually think about these numbers, the potential contribution of inventory investment is even more dramatic. If inventory investment goes from subtracting 0.49% from GDP (as it did over the last 4 quarters) to adding 1.12% to GDP (as I'm arguing it could well over the first four quarters of the recovery), the contribution to the growth rate of real GDP would be 1.12 - -0.49 = 1.61%.
|avg exc 1950||1.6|
How plausible is such a number? The table at the right reports the average contribution of inventory investment to real GDP growth over the first 4 quarters of each of the previous 10 expansions. Inventories made a positive contribution in every case, giving an average kick to real GDP growth of 2.1%. However, that average is heavily influenced by the outlier associated with the Korean War. Leaving 1950 out, inventories contributed an average of 1.6% to real GDP growth in the first year of previous expansions, exactly the amount I'm claiming they might be expected to contribute this time as well. That calculation reflects both the fact that the inventory liquidation this time has been more significant than in an average recession (on which basis you'd expect inventory restocking this time to be bigger than average) and the time trend's presumed decrease in the desired ratio of inventory investment to GDP (on which basis you'd expect inventory restocking this time to be smaller than average). From my quick calculations, those two factors exactly balance each other out, and I would expect inventory investment to be able to make the same significant contribution it has made in previous recoveries.
I have reviewed this potential for inventory investment, but similar dynamics also apply to a number of other components of GDP. For example, recent sales levels for motor vehicle appear to be significantly below normal scrappage rates, and this is another area where a big rebound effect is quite possible.
So why would anyone predict anything other than a robust rebound? General Electric Co. Vice Chairman John Rice expressed the core concern:
We see a world where good companies and good consumers can't get all the credit we would like," Rice said. "Companies with lots of cash on their balance sheet are worried about whether they will get what they need for working capital" and are cutting spending. "Until that changes I don't think you will see a significant rebound," Rice said. "We are preparing for 12 or 18 months of tough sledding."
The question is whether our financial system is willing and able to extend the credit that would fuel the recovery. The key battering ram so far has been the deterioration in the value of residential-mortgage-backed securities aggravated by the collapse in real estate prices, which collapse could easily continue. Calculated Risk doesn't share the enthusiasm over the latest house price numbers:
So house prices were falling at about a 10% annualized rate in April-- and that apparently feels like "stabilization"!
Will we see a robust recovery? I can't rule it out. But personally, I'll believe it when I see it.
Posted by James Hamilton at July 1, 2009 01:41 PMdigg this | reddit
I think robust recovery is the wrong description. After the 1980 very deep recession there was a sharp rebound...for a year.
There may well be a sharp rebound this time too, in fact based on historical experience this seems very likely, but whether that is a robust recovery depends what happens after the inventory spike, in other words in 2011 not 2010.
Posted by: bill j at July 1, 2009 02:05 PM
The stock market is also signalling a less than robust recovery, much as it has since bottoming on 9 March 2009.
Since then, stocks have largely risen to their current level largely due to investor expectations that things will not getting worse - that outlook has provided the positive acceleration we've observed behind the upward movement in stock prices. At present, investors would appear to expect conditions to remain fairly flat through the end of 2010, although with slight improvement in the second half of that year.
Posted by: Ironman at July 1, 2009 02:38 PM
The recovery will not be robust, since inventory was less than half of what caused the sharp drop in the first place.
Thus, the inventory rebuilding will move us from 'recession' to 'weak recovery', but it cannot do more than that.
Plus, excess housing inventory will be a drag for quite some time, as population only grows by 1% a year, and thus it will take 2-3 years to absorb up excess housing supply.
Posted by: GK at July 1, 2009 03:24 PM
"The question is whether our financial system is willing and able to extend the credit that would fuel the recovery."
To me, the question is how soon consumers can repair their damaged balance sheets. IMHO, this will take some time, a lot more than 12 to 18 months. The quote seems like an ad paid for by legacy lenders who insist it is credit supply that is constrained, rather than the demand, so the road to recovery requires that they be made whole for their bad loans. IMHU (again) this is a road to disaster.
Posted by: don at July 1, 2009 04:00 PM
"There's been an improvement over time in inventory management, which I captured with a downward-sloping linear time trend."
Could the slope also reflect that we have been moving away from manufacturing and toward services, and also that goods are getting cheaper relative to services? If I remember correctly, Valarie Ramey, in her Handbook chapter, graphed real on real, despite your warnings, and found no downward slope. Perhaps next time you see her in the corridor you could ask about it...or tell her she did the wrong thing! Seriously though, I'm not convinced all, or even much, of the downward trend is due to better management.
Posted by: a student at July 1, 2009 05:36 PM
"The question is whether our financial system is willing and able to extend the credit that would fuel the recovery."
Professor Hamilton, isn't the problem really one of the household sector (and to a lessor extent, the business sector) having the ability to carry additional debt?
Household debt is already ca. 100% of GDP and 125% of income. Debt is now falling, but so are GDP and incomes, and assets have been hammered.
I've been looking at figures from the Flow of Funds data. For private nonfinancial debt/GDP levels to return to the 1998 level (134%), $6T of debt would need to be eliminated.
A lot of economists agree that some deleveraging must occur, but they never seem to get down to brass tacks. The big questions are, what is a manageable level of debt? And how do we get there?
I don't see how anyone can make any sort of projection about recovery unless they can answer those questions. Has anyone made estimates on this?
Posted by: Bob_in_MA at July 1, 2009 07:29 PM
Lending is key, and that is psychologically deterred by Lehman collapse still. As a fad, it may revive rather fast ( if Lehman collapse took 1 month than rebound may take 3 months). It should start in end of July.
I think any turbulent system (and e.g. DOW is a turbulent system) which is stretched as economy is now, will rebound in proportion to the strecth if not broken, may be for short time with following rather big amplitude oscillations. Because the energy ( i.e. capital) is not gone, it is still somewhere, in latent state.
The system can not be kept in such overstretched stretched position for long- it either breaks down, tires, - then we have a real disaster- or, if market forces are allowed enough share in working this out, it will shoot back.
I think after July, may be August it will be clear will be a real disaster (Dow goes down to 4500) , or rebound. I opt for second choice since otherwise we are in deep .., all of the world.
There is no way it can be a slow recovery- amplitudes, dynamics, forces at work are too big.
So it is either V shaped or, in to the abyss.
Posted by: Ivars at July 1, 2009 10:19 PM
"Col. Ayres, VP Cleveland Trust, predicts an abrupt recovery in stock and commodity prices by Labor Day due to current consumption exceeding production. Distinguishes between two types of depression, “V”-shaped and “U”-shaped."
23 June 1930
(from the "News from 1930" blog, great stuff)
Output comes in cycles, economic analysis more so.
Posted by: Ernesto at July 2, 2009 06:28 AM
How many angels can dance on the head of a pin? You know the one questions that is never asked? What if the angels don't want to dance on the head of a pin?
Economics is not 2 hambergers + 75 french fries = 1 lunch, economics is about if I want Chinese food has the government made conditions so bad that the Chinese restaurant has gone out of business.
Economics is not about what was the average of a series of past quantities. Economics is about the here and now. Will the Senate follow the house and pass Cap-and-trade and give us the largest tax increase in our nation's history, and will that tax increase contain tariffs on other countries who don't honor cap-and-trade and will that set off a trade war that will run up unemployment. Will all of this shoot any possible recovery in the foot and drive us into 20 years of economic stagnation?
Can you give me the formula that will answer that?
Academic economics has become a game of Sudoku, manipulating a bunch of numbers that gives an answer with no meaning other than we have played the game. Then in the end if the statistics correlate to what we measure in the future we pat ourselves on the back and play the game again. If they don't correlate them we begin the game again to calculate why we failed. But hey, it is just a game. Who cares about decisions that create unemployment, we have our game and according to the statistics you shouldn't be unemployed anyway so suck it up.
Posted by: DickF at July 2, 2009 06:53 AM
Inventory rebound will be much less. Global turndown, consumer led recession, paradigm shift, paradox of thrift
Posted by: Mark G. at July 2, 2009 07:57 AM
The visible foot of the Obama administration is surely no help to the forces of growth.
Posted by: Rich Berger at July 2, 2009 09:18 AM
I feel sorry for you that you have to constantly cope with us lesser mortals and that you seem to be an inherently negative person to boot. However, I would offer a recommendation that you do not waste your time reading then lamenting on a discipline you consider so utterly useless and arbitrary.
Posted by: Sean at July 2, 2009 11:12 AM
The 1991 rebound was anemic. Is that because the "inventory" being liquidated was property?
It could be argued that this turndown is primarily property led as well. Would that indicate the rebound will be similarly anemic?
Posted by: beezer at July 2, 2009 11:37 AM
If the people who use such statistics to "run" our lives would stop it and just let us trade free of their meddling, let us trade so that everyone is better off, I would gladly stop wasting my time, but alas, it is the number crunchers who determine the winners (themselves) and the losers (anyone successful).
I am involved in these discussions for the same reason I am involved in politics. I am trying to save my butt.
As an aside, if you didn't have the nanny state always making you pay for their meddling you wouldn't have to be a lesser mortal. You make that choice - at least as far as I am concerned; I can't speak for the central planners.
Posted by: DickF at July 2, 2009 12:59 PM
I think there has been a real sea change in US consumption, and political resistance to that sea change is unsustainable. Deficit spending and money creation are finding little traction in the real economy, and they are running out of time - already by next year the political winds will have shifted and governments around the world will be under pressure to cut spending. There are still large numbers of doomed mortgages to work through over the next two years, and the discrediting of "property ladder" investment ideology dampens prospects for even a longer-term recovery. The flip side of that story is that there will remain large numbers of underwater mortgages: homeowners committed to paying for the past bubble out of their future incomes. Meanwhile baby boomers are just beginning to wake up to the harsh reality that the vast majority of them can hardly afford to retire.
Posted by: Tom at July 2, 2009 01:13 PM
Really nice analysis. Very useful.
Posted by: Steve Kopits at July 2, 2009 01:18 PM
Someone posted a graph of durable goods inventory to shipments ratio this week. The line on the graph is swinging up pretty dramatically. Convinces me that we need to sell and ship a whole lot more stuff before we make more stuff.
Posted by: John Booke at July 2, 2009 05:33 PM
Remember when the crisis hit, and all those numbers went places they never went before?
And remember when it was going to cost $700b, and then $1.2t, and then $1.8t, $3t, $6t, $12t...?
And remember green shoots?
And remember when all those 2nd derivatives finally headed in the right direction... until recently?
What is it that makes people think this is a normal recession?
What are we recovering to? Back to what it was? Dear God; please stop kidding yourselves. How's your spending these days?
I'll never buy an expensive thing again. It took this crisis for me to realize I have all the crap I need.
Do you think I'm alone?
Posted by: K Ackermann at July 3, 2009 01:25 PM
V or U?! C'mon!
How about W (double dip), L (90s Japan) or VL (GD) shaped curves! Now we're cook'in!
Inventory levels have nothing to do with this ...except housing inventories. This is about the credit bubble that has been growing since the 80s.
All that credit was just borrowing money from the future to provide immediate gratification NOW. The game is over ...we have to reset to a sustainable growth level.
I'm thinking the way we are printing money to provide welfare to insolvent banks ...we will be lucky if we end up with an L.
Posted by: Jim at July 4, 2009 11:45 PM
I am a bit confused. I took a look at the inventory cycle, i.e. how much did destocking cut off GDP during this recession compared to past recessions and found that this recession's inventory cycle was rather muted. Secondly, when you take a look at inventory levels, i.e. inventories in relation to sales, these are still extremely high. Of course for GDP, what counts is the second derivative, i.e. if the destocking slows, this will push up GDP. But the question is how much it will slow when the level of inventories is so high.
Posted by: Tajee at July 20, 2009 09:01 AM
Tajee: The data are plotted above. What numbers are you looking at?
Posted by: JDH at July 20, 2009 09:16 AM