The U.S. Recession Will Be Painful – But it Could’ve Been Lots Worse
By Martin Hutchinson
Contributing Editor
Money Morning
The U.S. economy is entering a recession. With each day that passes and each indicator we see, that eventuality becomes more and more clear.
Even so, we can take some real comfort in knowing that we’re likely going to avoid the “bottomless pit” of a Great Depression II. A substantial recession with accompanying inflation – roughly along the lines of the downturns of 1974 and 1980-82 – seems the most likely scenario we face.
The last two U.S. recessions – the 1990-91 downturn touched off by Saddam Hussein’s invasion of Kuwait and the subsequent recession in 2001 – were both short and shallow, and perhaps even unnaturally so. Gross domestic product (GDP) declined by about 1.5%, peak-to-trough, in the first case, and a mere 0.5% in the second.
In 1990-91, the tax cuts and other structural changes made by President Ronald W. Reagan had increased the trend growth rate of the U.S. economy, so only the artificial drag of the savings-and-loan crisis brought a modest recession. In 2001, the U.S. Federal Reserve was expanding the money supply so rapidly, and dropping interest rates so far below the level of inflation, that what might have been a substantial downturn after the 1996-2000 stock market bubble was turned into renewed recovery led by the housing sector.
The Portrait of a Downturn
Thus, our experience of the last two decades, when recessions have been both shallow and short-lived, is not necessarily what we should expect going forward.
This time around, it is fairly clear the recession will be deeper than in 2001, and perhaps even worse than its 1990-91 counterpart. Retail sales were down 1.2% in nominal terms in September and industrial production was down 2.6%, while unemployment has already risen from 5% to 6%, with payrolls dropping more than 600,000 since the start of the year. That suggests that an overall decline in output of considerably more than 1.0% to 1.5% is highly likely.
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At the other extreme, and very thankfully indeed, we are highly unlikely to see The Great Depression – The Sequel. Creating the first Great Depression required a horrific stock-market crash, followed by several major policy miscues. Key among them:
- A huge increase in tariffs (The Smoot-Hawley Tariff Act of 1930) at a time when world trade was already in a fragile state, and trade barriers were much higher than they had been before 1914.
- A 30% decrease in the money supply caused by bank failures, which made prices drop 20%, made real interest rates correspondingly high and was a major cause of real GDP dropping 25%.
- A major tax increase at the bottom of a deep recession, taking the top marginal rate of income tax from 25% to 63%.
This time around, we have already bailed out the banking system, are increasing the money supply at a rapid rate, and are fairly unlikely to enact a major tax increase in the trough of a recession. And even if protectionism revives, we are unlikely to see a re-run of Smoot-Hawley (in any case, world trade remains very robust, indeed).
All these differences are protections against Great Depression II, and they should be sufficient. That’s not to say we aren’t still looking at a nasty inflation problem, which is a separate question.
It’s High, It’s Deep – and It’s Gone
To figure out how deep the recession might be, look at a few factors in the U.S. economy that have changed or need to change. The housing decline has wiped out about $5 trillion of the nation’s wealth, and the stock market fall has eradicated an additional $8 trillion; taking a reasonably pessimistic view of both would suggest a total eventual wealth wipeout of about $20 trillion.
Past studies have suggested that there is a “negative wealth effect” in a market crash, with an annual consumption decline equal to about 3% to 4% of the wealth wiped out: In other words, for each $100 a consumer loses, they will reduce their outlays by $3 to $4. That translates into a consumption drop of about $600 billion to $800 billion, which equates to about 4% to 5% of our current GDP.
To look at this another way, the U.S. payments deficit is now around $750 billion per annum, or 5% of GDP, and will need to be eliminated – or nearly so – since foreigners won’t want to go on pouring that amount of money into the U.S. market. That also suggests a re-balancing of U.S. trade by about 5% of GDP. This rebalancing will probably come partly from decreased consumption, which itself will reduce imports, and partly from a decline in the value of the dollar, which will increase exports.
Finally, the abysmal U.S. savings rate is currently around zero, or maybe 1% of GDP, and has historically been around 5% to 6% of GDP. This also suggests a switch from consumption into saving of about 5% of GDP, although that’s realistically probably a very long-term change.
Those factors all tend to suggest a GDP decline of around 4% to 5%, top to bottom. That would be a little more than the recession of 1974, or the “double-dip” recession of 1980-82 – each of which equated to about 3.5% of GDP. However, as occurred in 1980-82, the anticipated decline is unlikely to happen in one leg, but will probably take a “double-dip” form. That’s because interest rates are currently very low, far below the rate of inflation. Hence, inflation will probably accelerate, alleviating the housing problem (because incomes will rise approximately in line with prices, making housing more affordable).
Once home prices have bottomed out, and the housing market has stabilized, banks will resume lending more aggressively and the economy will move into a full-fledged recovery mode.
Where Are You Paul Volcker?
At that point, since interest rates will have been far below inflation for several years, inflation will have accelerated, and will be accelerating harder. Hence, a change in U.S. Federal Reserve policy will be needed – probably one that pushes short-term interest rates far above the rate of inflation, as then-Fed Chairman Paul A. Volcker did from 1979 to 1982, a painful-but-effective assault on inflation, that sent pricing pressures packing for two decades.
That will inevitably cause a second “dip” in the economy, but by this stage the housing and financial sectors will have stabilized, and the second “dip” will be focused on corporate profits and the “real” economy. Profits’ share of GDP, which has been at an all-time high recently, will decline to more normal levels.
That is an unpleasant picture. It is bad news for stock prices and it may take five years to work through, albeit with a likely mild “bounce” in the middle.
But it could have been much worse. It’s nowhere near as bad as the nightmarish Great Depression, or the long, drawn-out and relentless rolling Japanese recession of 1990 to 2003, which led to that country’s “Lost Decade.”
And for that we must be grateful.
[Editor’s Note: When it comes to investment banking and the international financial markets, Money Morning Contributing Editor Martin Hutchinson brings readers a unique brand of expertise. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo. And readers have benefited: Back in April, long before the collapse of American International Group Inc. (AIG) made “credit default swaps” a household word, Hutchinson penned a column warning Money Morning readers about the dangers of credit-default swaps, and his recent analysis of how the U.S. stock market would respond to the credit crisis proved to be incredibly accurate. Hutchinson is also a regular contributor to our monthly investment newsletter, The Money Map Report. And right now, new Money Map Report subscribers will receive a free copy of The New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse” – which, ironically, details the moves investors have to make to generate large-scale profits in a volatile, or even upside-down, stock market. The strategy is one of the best ones we’ve seen for navigating the current financial crisis.]
News and Related Story Links:
- Money Morning Special Investment Report:
Six Ways to Play Money Morning’s Prediction That Gold is Headed for $1,500 an Ounce. - Wikipedia:
Ronald W. Reagan. - Wikipedia:
The Savings and Loan Crisis. - TutorTU:
Signs of a negative “wealth effect” for the USA? - Wikipedia:
The Smoot-Hawley Tariff Act of 1930. - Wikipedia:
The Great Depression. - Money Morning Special Investment Research Report:
The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it (Part I of II). - Money Morning Special Investment Research Report:
The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it for Profit (Part II of II).
Comment by Milton Crenshaw on 22 October 2008:
So we are going into a recession. Who didn’t already know for the past year or more that normal every day life wasn’t looking so rosy? My friends and I just say that things look bad…that’s what we call it while you it a recession. As far as I’m concerned, they are the same thing and dwelling on either term won’t make things better. Forget getting hung up on terminology and discuss ways this pickle-of-a-mess can be overcome…or at least dealt with in our everyday lives.
mpc
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Comment by Norman Prevatte on 22 October 2008:
The main cause of this disaster is that of the U.S. Congress. These people have one objective: get re elected. That way they can continue to participate in the kickbacks and corruption. How do we fix it?
TERM LIMITS (2)! That way we can clear them out before they cause too much trouble. I do not care what party they are in. Both Republican and Democrat are equally responsible. Get rid of them!
Norman Prevatte
Comment by Rick on 22 October 2008:
There is at least one question, which obviously must come to any thinking person’s mind:
How on earth will the US payments deficit to foreign countries, which is now around 750 billion per annum, be eliminated or even reduced? Already, foreign exporters don’t want to continue pumping goods into the US without payment in return.
Furthermore, and most ominously, foreign suppliers to the US, or to anyone else, can’t afford US dollar valuation of their stuff for sale. US dollar valuation prices are too low and going lower and lower, still. Even on home turf, there is a total US dollar wealth wipeout of some 20 trillion dollars. So US dollar valuation everywhere continues to be watered down.
Suppliers, therefore, of critically needed commodities like oil, demand “new price” tags on their goods, which will give them the kind of value they both, need, and want. So, probably sooner, rather than later, suppliers will disconnect from the US dollar altogether, in favor of some “other” valuation device.
Comment by Ed on 22 October 2008:
Most people seem to be still shopping on Saturday afternoons (check the traffic yourself). If a story is told often enough it can become a self-fulfilling prophecy and that seems to be what is happening here now. Not that we don’t have a real and genuine financial crisis to work through but rather that there has been much fuel thrown on the firepile from media sensationalizing and the reactive panic of the masses. Our economy and all economies are based upon faith. We believe in the value of our money and that we will be able to barter with it for our lives resources. This faith is tested when we see the value of our assets decline and many react by preserving their capital and pulling it out of the markets. Unfortunately it is these very markets that generate the substance for our faith so we end up hurting our overall economy in the process. I am following Warren Buffent and am buying back in after sitting on the sidelines since December of 2007. I believe in our faith, our country, and our people. We will get throught this and come out strong.
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Comment by Rob Murphy on 22 October 2008:
Good afternoon,
You make your case well but you didn’t address a few very important considerations.
You are correct when you say that the current account deficit is 5% of GDP and will have to be eliminated, or nearly so. That, however, seems a very optimistic assumption on your part. How do you think that might occur? And over what time period? The drop in oil prices will definitely help but the dollar has soared against the euro and now our exports there are nearly 20% more expensive than they were a month ago. With Europe and the rest of the world entering a recession, how much demand will there be for our exports? Further, all these countries entering recession are going to do whatever they can to keep their economies strong. They need to export to the U.S. to keep their citizens employed. These countries will subsidize their exports, peg their currencies, reduce profit margins, accept reasonable losses – anything to keep their citizens employed. Expect modest improvement but nothing significant unless the recession is very severe.
Then of course, there are the twin deficits. Next year’s Federal budget deficit may reach $1 trillion dollars. Does that matter in the scheme of things? Does it matter that every man, woman and child owes over $30000 because of the budget deficit and at least another $17000 because of the current account deficit? Do you realize how much those obligations would soar with a 2%-3% increase in interest rates? Do you think our foreign creditors are going to be happy with the U.S. taking on all this debt?
And what happens when all of our foreign creditors realize one day that no matter what they sell us and what the terms are, the only thing they are going to get from us is more IOUs?
There’s alot that can still go wrong?
t
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Comment by Joe Lawler on 22 October 2008:
I will keep this short because I can’t believe the amount of time I used reading your opinion. I appreciate the fact you allow for others expressing theirs.
It appears to me that you are jumping to conclusions by mentioning “it Could’ve Been Lots Worse”. I believe that is past tense and from quick glimpse, you failed to mention two (2) very critical points.
(1) What about the amount of derivative financing that has yet to be felt in the Credit market when the Corporate world starts to feel the shakeout of all of this. Do you really believe the $700 bn bailout is all that was needed? One of the chief cohorts named Ben Bernanke has already approached Congress in the normal cowardly fashion by strongly HINTING to additional funds that will be necessary and that the market will take time to recover. That is a frame up!!! When the true impact of this starts hitting the Corporate world that Ohhhh Bama says he wants to tax and share wealth from … either one in itself will produce reason # 2 for supporting the view that we are just entering into the 3rd inning of this game.
(2) When corporations feel the sting and are looking at facing cuts in order to afford losses and / or additional taxes / forced health care, they will be faced to reduce their workforce. The last time I checked, that actually increases unemployment numbers which in turn SLIGHTLY impacts the already concerning economic woes that “could have been a lot worse”.
Then again, maybe I have perceived something I should not have, because this “Could’ve been a lot worse”, had it not been for the fact that the enemy to this entire situation is also our strongest ally. True Americans are those who do not believe lies, although “unfortunately are sometimes deceived by some whom they at times are required to place their trust in.” That would be more of an issue of corrupt behavior than that of believing a lie. Truth is, Americans have been lied to and swindled to for too long and their is an awakening.
I agree with another comment on Term Limits. What is wrong with 1 (6 year term) across the board? In and out – One term only and rebase our economy off of a new currency and phase out fractional reserve lending that is encouraged by the Federal Reserve who holds our country hostage. Yes, the Federal Reserve, synonymous with JP Morgan- Chase, Morgan Stanley, BIC, World Bank, David Rockefeller, International Committee on Foreign Affairs etc. etc. etc. …. We can, should and owe it to ourselves to stand up for Liberty and call a spade a spade and quit trying to fool ourselves into believing we have escaped the grasp of “The Sequel to the Great Depression”. It is nearer than we think if we believe this mess we are in is less than what it really is. I firmly believe that is likened to predicting either Tampa Bay or Philadelphia to win the series in 3 games.
Actually, now that we are talking baseball, I’ll take Philly in 2.
There is more, but I’ll stop here.
Respectfully,
Comment by Theo Nykos on 23 October 2008:
I truly disagree! It has costs much loss but too many who have lost are now reaping will gains within the Market and this is still creating the Big Economiic Morass! This system MUST be destroyed and a new one created!!!
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