The U-V-W Scenarios Of Recession

Indian industry will remain in the dumps till the global recession ends. Many believe the recession has touched bottom. But will the recovery be swift or painfully drawn out? Doing the rounds are theories that I call the U, V and W scenarios.

Economic optimists predict a V-shaped recession. That is, a sharp fall followed by an equally sharp recovery. These optimists predict that the US economy will shortly soar.

The pessimists, including Martin Wolf of the Financial Times, fear that a short recovery will be followed by a second downswing. That will mean a W-shaped recession, with two dips.

Mainstream analysts predict a U-shaped recovery. They seem to favour two main ways of drawing a U, the bathtub and the saucer. The bathtub implies a trough followed by fairly sharp recovery. The saucer implies a long, slow recovery, going well into 2003.

Some say there has been no recession at all since American GDP declined only in one quarter, July-September, and then grew by a marginal 0.3 per cent the next quarter. However, most experts agree that the recession is a reality, and so is the accompanying pain.

So will the recovery be a U, V or W? Forget the V. The downswing from the peak started in late 2000 and has been followed by a trough running for several quarters. Even if the US recovers sharply in the next two quarters, the outcome will be a bathtub U, not a V.

Bathtub theorists note that the average duration of a recession since 1960 has been 11 months, so the current one starting last March should be about to end. US inventories levels have fallen sharply, interest rates are exceptionally low at 1.75 per cent, and that should spur rapid recovery.

Not so, say proponents of the saucer-shaped recession. They say recessions in recent decades were caused by a fall in consumer demand, typically induced by monetary stringency to choke off inflation. But consumer demand has stayed up in the current recession, the big problem being the collapse of corporate investment. This, they argue, is more like the investment-led recessions of the 19th century, that lasted two to three years on an average. Very elongated saucers indeed.

Proponents of the W theory say that the excesses of the 1990s have not yet been worked off fully. The stock markets have not really returned to earth. The P/E ratio of the S&P 500 is currently 38, against just 6 at the bottom of earlier recessions. Consumer savings remain exceptionally low and debt unsustainably high, say these pessimists. Even if a recovery starts, consumer spending may dip again in response fears induced by high credit card debt or another stock market decline. If so, a W-shaped recession will follow.

All these analyses have a huge blind spot. They pay too much attention to industrial activity, and too little to services. The US economy and the global economy have shifted inexorably towards services in recent decades. In the US, the share of services is now 71 per cent in GDP and over 80 per cent in employment.

The main reason why recessions have become shorter in recent decades is not that they have been caused by a fall in consumer spending, unlike the long recessions of the 19th century caused by falling investment. The main reason is the massive global shift from goods to services. The demand for services is more stable than for goods. Education and health care are pretty recession-proof, and now constitute major chunks of the economy. So forget analogies with the two-year recessions of the 19th century. The bathtub looks more plausible than the saucer.

Unlike goods, services cannot be stored. Unsold TV sets can be kept for later sale, but unfilled airline seats or hotel rooms mean irretrievable loss. This affects the inventory cycle. When demand for goods falls, inventories pile up, and production is cut only with a lag. This cushions the downswing. But when consumer demand recovers, it first mops up unsold inventories and only then induces more production. So recovery is delayed too.

Not so in most services. Falling demand translates instantly into empty airline and theatre seats. There are no unsold inventories, so the downswing is sharp. For the same reason, the upswing is sharp too: No unsold inventories need to be liquidated.

I believe that the current global recession is best understood as having two layers, manufacturing overlaid by services. Manufacturing, the lower layer, started declining in late 2000, but did not translate into a decline in GDP because services, the upper layer, remained strong.

Then came the Al-Qaida attack in September. Air travel, tourism and entertainment collapsed. The service layer collapsed over the already depressed manufacturing layer, and GDP slumped.

Why did GDP growth turn positive again in the October-December quarter? One reason was the boost to car sales from zero-interest schemes, which are, however, not sustainable. A bigger and more sustainable reason is that services are recovering from 9/11. Data from the US suggests that the decline in air traffic, which touched 40 per cent in September, eased to 14 per cent by December. Data from Europe indicates that air traffic in the second week of January was back to the level a year earlier. If allied services like tourism and entertainment follow a similar trend, that implies a pretty strong recovery. A veritable bathtub.

But don’t cheer too soon. Remember that Islamic terrorists will surely strike back soon, and more than once. President George Bush has warned of a thousand ticking human time bombs. Some will be apprehended before they explode, but surely not all. Fresh bombing outrages could occur soon, possibly even a dirty nuclear bomb in a key city like Washington or London. That could mean another economic plunge, and a W-shaped recession.

So do not place too much faith in recession analyses relying heavily on economic theories. Osama bin Laden could determine outcomes far more than Alan Greenspan.

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