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Thursday, June 4, 2009

L, U, V, and W

I have made no secret that I remain very bearish on the future of the economy. Yet, even I believe that soon enough we will see a recovery. In fact, if you are extremely bullish, you believe that the recovery is just now starting. If you are bit less bullish, you think in the next three months it will begin. If you are very bearish, like me, you don't see it until well into next year. Some are even more bearish than that. Still, in the next two years, at most, the economy should bottom out and begin its recovery.

Much more importantly is the shape of the recovery. Recoveries generally are shaped in one of three ways: an L, a U, and a W. It is the shape of this recovery that will be significantly more important than the timing of the recovery itself. That's because the shape of the recovery will guide the relative strength of the economy for the next decade or more.

An L shaped recovery is the worst kind of a recovery. An L shaped recovery happens when the economy bottoms out and then doesn't begin to grow for years if not decades. The best example of an L shaped recovery is what happened to Japan in the 1990's.

A U shaped recovery is the best kind of a recovery. In a U shaped recover the economy slows contracts and then just as slowly comes back out of the recession. Obviously, in this economy, the economy didn't contract slowly. The best example of this was the 1970's.

A V shaped recovery happens when the economy tanks quickly. Then, it recovers just as quickly. This happened both under Clinton in 1993 and Bush in 2001-2002.

The W shaped recession happens when the economy creates false recoveries on the road to recovery. In such a case, the economy shows signs of recovery only to fall back into a recession. In such case, the recovery last years if not decades. This is in fact the way the recovery occurred in the depression. As you can see, the economy bottomed out in 1933. Then it rose, tapered off, dipped, before finally coming out of it because of the war.
So, which sort of a recovery will we see this time? That remains to be seen but I believe the nature of the recession is a far better judge of the economic policies of a president, and the Fed, then just how slowly or quickly an economy happens to come out of the recession.
I believe that we will see this W shaped recession. It's why I am still bearish. Whatever short term signs we see of a recovery, they are, in my opinion, overwhelmed by the long term problems caused by the action in response to the recovery. In other words, I believe the medicine will wind up worse than the ailment.
Between the Fed's quantitative easing (creating money out of thin air and buying bonds with it), the massive stimulus, the bank bailouts, all of these things have run up our debt to massive levels. What does this cause? First, it causes higher interest rates, high inflation, and a weak dollar. Already, we are seeing signs of the negative effects of this. Oil has steadily been rising over the last two months. That's partially to do with the dollar, as oil is priced in dollars.
What will $3 a gallon gas prices do to our recovery? I have spoke often about the rising interest rate in the Ten Year U.S. Treasury. That's back to just under 3.7%. This has recently caused a massive short term run up in mortgage rates. What will 6% or even 7% mortgage rates do to our recovery?
Finally, there was the bank bailout. Both Obama and Bush before him often cited the bailout as keeping us from the brink of a total financial meltdown. That's possible but it also created sort of zombie banks that are really never in a position to do normal business. So, maybe these banks were walked back from the edge, but they aren't going to be in a position to significant business for a long time. Is that better than letting them fail? That will be debated.
All of this spending and borrowing will eventually create inflation. That inflation will happen when the economy begins to recover, if not sooner. That will force the Fed to either allow inflation or control it by selling back the very bonds they are buying now. Buying back bonds will cause interest rates to go back up. That will of course stunt the recovery and cause the W shaped curve that I predict.
Beyond the technical economics of all of this is the very real pain that a W shaped recovery would cause. We would see an economy sputter and start and sputter again. Businesses will invest only to see the economy weaken. People will start to go back to work only to have unemployment weaken again. There will be hills and valleys which on a graph looks interesting. In real life, it will be years of pain, and it's what I predict for the economy going forward.

1 comment:

islandminister said...

Great post! Thanks for your insight, and I agree with you on the W.