Spiral of pessimism

All this pessimism comes despite data that still does not indicate that the US has entered a recession. Trends in employment, retail sales and industrial production show domestic demand has indeed slowed to a crawl, but is far from falling off the cliff. In addition, export growth remains robust and is on track to add almost a percentage point to US GDP in 2008. While it’s true that some of the data tend to lag behind current economic activity, so do the opinions of economists and the commentariat. In the past, they have not been able to distinguish a cyclical slowdown from a recession until the economy is midway into the event.

So either history is going to be turned on its head this time, with the consensus announcing a recession well before it has arrived, or all of the current fuss is going to seem like a bit of a hoax. At the moment, the latter outcome looks more likely.

While it’s hard to deny that the US is in throes of a full-blown credit crisis, a look back at similar episodes in the developed world and a closer examination of the wider economy suggest that the US is well poised to skirt a recession. The typical conditions that cause a recession, from inflation to widespread investment excesses in capital spending, do not currently exist. Furthermore, past credit crises have not always led to economic slumps.

The more mature phase of a long expansion cycle involves an outbreak of higher inflation, prompting monetary authorities to aggressively increase interest rates. As inflation is mostly the product of diminishing productivity gains and declining profitability following years of investment, the corporate sector is then forced to aggressively cut spending and jobs to meet profitability targets.

Of course, the Fed did increase interest rates from 1 per cent in 2004 to 5.25 per cent in 2006, but that was more about normalising interest rates after an extended low-rate regime. Monetary policy never got too tight in the US, and inflation has not been a serious problem in the present cycle. As a result, the Fed is now in a good position to aggressively cut interest rates.

More importantly, apart from the troubles in the financial sector, US corporations are in fairly good health. Profit margins are close to all-time highs and investment levels are in line with historical norms. US firms did not succumb to overspending during this business cycle, as scars from the 2001-02 recession were still raw.

During recessions, payrolls decline by a massive 2,15,000 heads a month; at present, however, modest increases are still underway. If companies do not feel the pressure to lay off workers and income growth keeps rising moderately, the consumer will retain enough of a cushion to weather the turmoil. It is important to remember that unlike corporations, consumers don’t change their behaviour overnight. While it’s almost certain that there will be a downshift in spending habits in response to the housing market shock and tougher financial conditions, any drastic change seems unlikely.

Chances are that what we’ll see instead is many quarters — if not years — of sub-par growth in the US economy, not a dramatic downturn, as both the consumer and financial sector gradually rebuild their balance sheets with help from policymakers. The negative effects of credit crises tend to linger for years, since the bias of a democratic system is to amortise the pain over time rather than swallow it in one shot.

Such a scenario may not be the most desirable outcome to the economic purists who would rather see all problems liquidated immediately. However, for the investors, any outcome that stops short of a full-fledged recession will feel like an early spring after a long winter of discontent.