In the midst of the worst US economic recession in the post-war period, it is all too natural to be looking to high frequency economic data for signs of green shoots that an economic recovery might have begun. However, rather than grasping at straws, US policymakers would do better to honestly ask themselves the following two questions. Have the policy measures taken to date been commensurate to the enormity of the challenges posed to the US economy by the most severe asset price and credit market busts since the 1930s? Are we taking sufficient note of the adverse impact that the deepening economic crises in Europe and Japan will have on our economy?

            The new Administration has correctly diagnosed that extricating the US economy from its present economic malaise will require coordinated policy action on three fronts. First, they recognize the need for an appropriately sized and well designed fiscal stimulus package. Such a stimulus is sorely needed to offset the very large negative impact on household consumption caused by the destruction of around US$14 trillion in US household wealth. Second, they acknowledge the urgent need to recapitalize the banking system in order to get credit flowing again through the economy. And, third they accept the need for bold policy measures to stem the present wave of foreclosures as the means to stabilize the US housing market.

As the actual details of President Obama’s economic strategy have now finally emerged, one has to be struck at the gaping gulf between the Administration’s diagnosis of what ails the economy and its policy prescription to promote a recovery. Particularly disappointing is the US$800 billion fiscal stimulus package. For far from being front-loaded, as the immediate downward economic spiral would seem to dictate, it defers its major impact to 2010 and 2011. And far from focusing on measures that would get the most “bang for the buck”, it relies too heavily on tax cuts of the sort that singularly failed to boost the economy in 2008 and on infrastructure spending that by its very nature are slow acting.

Equally perplexing is the fact that, instead of addressing the bank insolvency issue head on, the Administration is choosing to continue the charade that the banks’ problems are largely those of liquidity rather than those of solvency. As Tim Geithner’s most recent presentation of his bank rescue plan reveals, the Administration is choosing to pursue its own version of the failed TARP policies of Hank Paulson. For rather than following a “good bank/ bad bank” model that might actually get bank lending flowing again, Geithner is restricting himself to engineering the purchase at fair value of around US$1 trillion of the banks’ toxic assets. He is doing so seemingly oblivious to the unfortunate Japanese experience in the early 1990s of supporting zombie banks that led that country down the road to deflation.

In a robust global economic setting, an inadequate domestic policy response would be unfortunate. However, the global economy is anything but robust. Eastern Europe is on the verge of a wave of defaults that will reverberate through the West European banking system; visible cracks are now appearing within the Euro-zone itself; and Japan’s economy appears to be in a freefall that the Japanese authorities appear to be incapable of stopping. This difficult global economic background would seem to heighten the urgency that US policymakers refrain from wishful thinking about an early bottom to our economy. Rather one must hope that they seriously consider their options for revamping the policy strategy in place to adequately address our worst economic crisis since the 1930s.  

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To think clearly about what might signal the end to the recession, we need to understand what recessions have been like historically. Maybe you need to see this all laid out in my new book, Macroeconomic Patterns and Stories.

Since World War II, we have experienced eight consumer downturns and two "resets" to use the term currently in vogue. One reset was the 1953 Department of Defense downturn caused by a huge drop in spending by the DOD when the Korean armistice was signed in July 1953. That was a reset - back to a peacetime economy. The other reset was the 2001 Internet Comeuppance caused by a huge drop in spending by business on information technology when it became clear that the Internet was a profit killer, not a profit center. IT spending was reset to normal levels.

The other eight previous recessions have been consumer cycles that have all experienced the same temporal sequence of problems: first homes, then cars, then business spending on short-lived assets and finally, much delayed, business spending on long-lived assets. That is the ordering of the problems, but the recovery had exactly the same ordering: homes improved first, then cars, then equipment and last, much delayed, structures.

For these consumer cycles with housing leading the way, building permits is among the best predictors of the end of the downturn, but the stock market does a better job, giving us fairly reliable announcement of good time coming in 3 to 4 months. (See the charts below.)

But, in truth, though there are fairly reliable indicators of oncoming recessions, including an inverted yield curve and a decline in housing starts, there is nothing nearly so good for telling when a recession will officially end. You should probably be thinking of a recession like the drawing of a V on the board. You cannot tell how far down the first stroke of the V will go. Suddenly it just starts upward. Or in the advice of my mother: It's always darkest before the dawn.

Beyond the general lack of reliable indicators of ends of recessions, knowing where we are right now is made all the more difficult by the unusual nature of this recession, most notably housing, lending and our balance sheets. Is this a typical consumer downturn, or a severe reset, the likes of which we have never experienced before? Housing peaked a very long time ago - at the end of 2005. Usually housing leads a recession by only 3 or 4 quarters. With home prices still declining and foreclosure still elevating, can we expect housing to power us out of this mess? Then there seems no end in sight to the troubles in our lending institutions. Seems like we are in a chicken and egg situation - no lending without a recovery, and no recovery without lending. Last of all, there is the heavy-in-debt overspent consumer whose balance sheets have been dramatically clarified: you are not nearly as well off as you thought you were. That has led to a surprising increase in saving, which really accounts for the cliff we fell off in the fourth quarter of last year. Maybe, this time, the personal savings rate is the right leading indicator.

I am both utterly confused and completely optimistic.

(click to enlarge)

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