24/09/2010: Will that be one dip or two, or even more?

Finally, some good news: the US recession is over. According to 21^st September’s announcement by the Business Cycle Dating Committee of the National Bureau of Economic Research, it apparently already ended back in June 2009, or didn't you notice?

At the least, we find the timing of this assessment rather odd, since one of the most hotly debated questions today is whether the US has already slid back into recession, into the famous double-dip.

There are no easy answers here. While some leading (forward-looking) indicators suggest a renewed recession scenario, others are still flashing the green light of growth. And for the nearly 10% of the US workforce that is unemployed, it must feel like the recession never even paused for breath.

But I think the double-dip debate could be missing the point. Let me explain: Over the past two years, I have not heard a single economist suggest that escaping the post-financial crisis recession would be easy in the US. Most observers have predicted a recovery that would be much slower than those following previous recessions. The reason: one of the traditional engines of growth, a flourishing housing market, would obviously be missing around this time.

Looking at the "shallow recession" of 2001-2002, it appeared that another jobless recovery was in the making. Moreover, the myth of the "flexible" US labor market, already questioned eight years ago, has been further undermined by the collapse of the housing market. In the recent past, an unemployed Californian, for example, readily moved to North Carolina for a job. Now, facing a big loss on the sale of his home, he will think twice before moving. And not only will his California house turn a loss; it will be tough to get a mortgage for a decent new home in North Carolina.

So, despite all the massive fiscal and monetary stimulus measures, given the role of house prices in the origins of the recession of 2008-2009, the slow recovery is unsurprising. But this is not the end of the story. I think that the financial crisis has done long-term, even permanent, damage to US trend growth. Some key numbers bear this sad thesis out. Before 2007, economists generally agreed that the US economy reliably grew by an average of 3 to 3.5% a year. After all, this level of growth had established itself over a quarter-century, since the 1980s – at least until late 2007.

That era of steady growth has come to a painful end, in my view. I would guess the financial crisis has probably cut growth by as much as 1 to 1.5%. Why? Three reasons: the relentless deleveraging of US households, tighter regulations on financial intermediaries and the ballooning US government debt.

In hindsight, I think we have to acknowledge that US growth between 2002 and 2007 was a sham, enabled only by the helium balloon of private debt. This is reflected in the US current account deficit, which had grown to almost 8% of GDP by 2007. And this was not the only imbalance: for years, the US simply consumed far more than it produced. Minus the surge in the current account deficit, a more sober estimate of US economic growth in the 2000s yields a figure closer to 2.5% than to 3%.

With US households now really starting to save in earnest – or, more precisely, to reduce their heady levels of debt – this illusory engine of growth is out of gas. The situation is only exacerbated by the extreme caution being exercised by financial intermediaries – the banks, insurers and other lenders. Whether due to tighter regulations or the need to repair their own distressed balance sheets, lending activity is tentative at best.

And there is yet one more arrow puncturing the US growth bubble: the government's various fiscal stimulus and bailout programs are pushing public debt to levels that threaten to choke off any real growth for a long, long time. This is the view expressed in a recent study by US economists Carmen Reinhart and Kenneth Rogoff, and it is hard to argue against it, in my view.

If the US only grows at 2%, instead of the previously assumed 3-3.5%, the double-dip discussion addresses only a part of the story of America's economic future. Such a modest level of growth makes slides into recessionary territory far easier than a growth rate of 3.5%. So instead of worrying about a double-dip, maybe we should focus more on the prospect of multiple dips in the future.

17/09/2010: The pride of apocalypse

The world is following economic developments with bated breath, looking for some sign of whether we are headed for a double-dip recession. A Swiss asset manager recently joined the debate: “No, there will be no double dip. It will be a lot worse. The world economy will soon go into an accelerated and precipitous decline which will make the 2007 to early 2009 downturn seem like a walk in the park.” The author claims that this correction could ultimately drag on for 100 years or more, swallowing up all the wealth generated since the industrial revolution. His conclusion: the situation is so dire that gold will become important “for wealth preservation purposes.”

These are truly unsettling predictions. The aftermath of the financial crisis sending us all the way back to where we were before the invention of the steam engine? But why stop there, perhaps we'll find ourselves at a point before the discovery of America, or before the fall of the Roman Empire. And with such a dark view, how do we know gold would be up to the task of buffering this destruction? A cattle ranch in Wyoming – with lots of guns – sounds like a safer alternative.

Moreover, 100 years is quite a long horizon for such uncertain claims. Even if this scenario comes to pass, the asset manager that conjured it up might not be around anymore to celebrate its prescience. I can't recall hearing about any medieval asset managers – with the exception of the Medici, of course. All joking aside, it seems far more likely that this dire warning will turn out to be wrong, just like every apocalyptic prophecy so far.

Why is it that these end-of-the-world stories continue to find such a strong foothold in the collective imagination? From John the Apostle to Robert Malthus, from Nostradamus to Oswald Spengler, from the ancient Mayas to the Club of Rome – doom and gloom simply fascinate us. Yet our contrary tendencies toward unwarranted optimism and overconfidence make clear answers elusive. Newlyweds expect their marriage to last a lifetime even though they are aware of the divorce statistics.

But overconfidence and excessive pessimism spring from the same source, although on the surface they certainly seem antithetical. Both draw their strength from the deadly sin that brought down the devil himself: pride. By a strange psychological twist, our fondness for apocalypse might be embedded in our vanity just as much as our inherent optimism. After all, what could make us more special than being part of the generation that sees the end of the world as we know it?

Whether we want to or not, at some point we all fall prey to this sense that we are special, standing out from the crowd. Unfortunately for our end-of-the-world scenario, these predictions have been around since the dawn of civilization and won't disappear anytime soon. Even from one generation to the next, we are inclined to complain that everything was better in the past and that young people have no respect – something Plato was already saying almost 2,500 years ago.

The post-financial crisis world is forcing us to sober conclusions indeed, but what we need now is careful analysis based on facts. Our current circumstances present challenges that may seem insurmountable at times – there is really no need to spread apocalyptic visions.

10/09/2010: A primer in postmodern economics

I recently read a research note written by a US bank’s chief economist, and it left me truly perplexed. My esteemed colleague examined the reported friction between board members at the Federal Reserve, paying particular attention to the tension said to exist between Fed Chairman Ben Bernanke and board members concerned about the long-term fallout from current US monetary policy.

His surprising conclusion was that if the Fed were to lose credibility, this would prompt an appreciation of the US dollar (yes, that’s right: an appreciation). I sent him an e-mail flagging this apparent error, but received an equally perplexing reply: “No, no, you read correctly: the less credible the Fed is, the more anxious market participants become and hence the more they will seek the dollar as a safe haven currency.” A discredited central bank as the catalyst for a strong currency – you must be kidding!

Surely this flies in the face of mainstream economic theory and its dearly held assumption that investors behave rationally. And yet, we must admit that the financial crisis has strained this model to the breaking point. Many other social sciences have been dismantling the concept of rationality for decades – you could say they have entered the postmodern age, where irrational thought and action are simply accepted as part of the landscape. Major postmodern thinkers, including late French philosopher Jacques Derrida, propose a worldview in which reason is no longer king. Is it time for economics to follow suit?

Without reason as our compass, we may start to fear that anything goes. But we would also do well to acknowledge that postmodernism seems particularly apt to describe behavior patterns seen during the crisis. Fads, fantasies and fashion have often played a more prominent role than dispassionate analysis based on facts. Fears and trends have followed all sorts of irrational trajectories.

If we concede that an element of irrationality helps drive the markets, have we declared economics scientifically bankrupt? The simple answer is no. But we do have to take another look at what we count as sound evidence when trying to make informed decisions about the future. It becomes crucial that we spot the risks stemming from irrationality in the markets, rather than placing blind faith in their rationality.

Economist John Maynard Keynes famously quipped that “the market can stay irrational longer than you can stay solvent.” Investors who don’t want to test this claim won’t speculate on rapidly rising interest rates just yet. But interest rates are indeed irrationally low – and governments have been on a wild spending spree – so investors must also resist the fashion for deflationism and those irrationally expensive government bonds.