What kind of Western recession?

Regular readers will recall that I began forecasting a Western recession some months ago. That judgement is now becoming mainstream. Last night, Willem Buiter called an imminent European recession. From Alphaville:

Even with a leveraged EFSF, additional fiscal tightening and tighter financial conditions are likely to be sizeable drags for Euro Area growth. Taking this into account, we revise down our Euro Area 2012 GDP growth forecast from +0.6% to -0.2%, now expecting a mild recession to start in 4Q 2011.

And a couple of night’s ago, the always excellent Gerard Minack also made the recession call for both Europe and the United States. The entire video from Lateline Business is worth your time:

You will have noticed that both of these recession predictions are based upon the same premiss, that Western governments will retrench spending causing their economies to slump into recession.

However, the last two day’s of US economic data has been reasonable. Yesterday Durable Goods Orders were stable, if not spectacular. And today, there was a revision up in 2nd quarter GDP, as well as a big fall in Weekly Unemployment Claims  (which is volatile and should be treated with caution) as well as, a fair result in the Kansas City Fed Index for manufacturing, suggesting Monday’s ISM result may be stable at around par.

So what gives?

As Minack says,  and I’ve argued for some time, a US recession is likley to come from the 1.5% or so of fiscal spending cuts that are being haggled over by the US Joint Select Committee on Deficit Reduction or “Super Committee”. With GDP already weak, such cuts are ipso facto a recession. Buiter has essentially used a similar calculus in his call for Europe.

But, with the US private sector data chugging along OK, if weakly, what kind of recession is it when public sector retrenchment causes a fall in GDP, rather than the route into recession that has typified post war business cycles, a tightening of monetary policy leading to a private sector bust? Fed watcher Tim Duy has put forward the case recession in these circumstances is not guaranteed:

I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year.  That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery.  As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels.  Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth.  Recession or not, a tragedy by any measure.

I won’t claim to be an expert on the Japanese economy, but there are few points one can make from the general macro data. First, here’s the post-bust history of Japanese GDP:

And the same time-frame for the General Government Deficit:

The first observation is that other than a small tightening in 1997, which ran headlong into the Asian Financial Crisis, Japan never tightened fiscal spending until the post-millenium global boom was ripping along, so we can’t really look to Japan to understand if it’s possible for the private sector to keep growing through a public sector retrenchment that results in overall economic shrinkage.

The fact is, the accounting identities of  sectoral balancing tell us that this is a very difficult act to achieve. If the public sector is shrinking, then either the private sector must be taking on greater amounts of debt or the external sector must be expanding for GDP to remain positive. With private sector debt stable and/or shrinking that only leaves exports to pick up the slack. For the US and Europe to  simultaneoulsy boost exports to offset other growth drags is also very unlikely.

The end result is that US and European fiscal retrenchment will most likely result in public and private sector job losses. These job losses will suppress already falling consumer sentiment and spending. That will result in rising inventories. Which in turn triggers the age-old business cycle response of further job losses in production and an inventory cycle.

So, even though fiscal retrenchment is an atypical trigger for recession in post-war terms, my bet is it will still trigger a typical post-war business cycle, within the larger structural adjustment underway in the balance sheets of Western governments and households. Which makes me think that it will be a deeper hit to growth than Buiter is currently predicting.


  1. Yes, the rebalancing is not yet complete. Nowhere near it. It may not even be possible without major social upheaval in the US. And we need to remember that any good data points in the US are happening in a context of ZIRP + QEx2. Built that’s not to say there won’t be some good bear rallies to trade …

  2. In the face of persistently high unemployment numbers, all these predictions about growth and recessions are meaningless.
    For those without a job, it is a recession right now.

  3. When it comes to US unemployment figures you need to keep in mind that unemployment benefits in the US are time-limited and so a decrease in benefit claims could mean that people are falling off the books and now don’t have any source of income.

  4. The axis of the Japan GDP growth chart seems wrong. At which point in recent history was their GDP growth above 5%? Similarly they didn’t have growth of 7.5% in 1991. Seems like the axis is doubling the correct figures.

    • The GDP chart is not inflation adjusted. I know it’s hard to imagine right now, but Japanese inflation was running at over 4% in the late 80s.

      • The graphs are different as one is GDP annual growth rate & one is GDP quarterly growth rate.

        The chart that H&H has used seems to be of the figures that are not commonly used according to the description.

        The site says “Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment”.

        I’m not entirely sure what that means and what the point is of coming up with figures for GDP growth that are wildly divergent in quantum if not direction.

      • Thanks Ronin – the chart above is nominal GDP growth. In real terms there appears to be higher volatility and more periods with negative growth than suggested by the nominal figures.

  5. All these experts claiming to have forecast a recession! As though it took some brains to forsee a unique event when you can’t help but trip over it? Get real and honest for a change. Blind freddie and his dog –anyone not inclined to succumb to the spin and doggeral of frantic politicians and central bankers –have been forecasting a recession for the past year or so…safe and secure from within the realms of an on-going recession and deepening depression.One of the key problems we have as a world society is the hubristic economists ( as a class) who know little of real worth and certainly have little touch with reality, have enormous egos, and are far too concerned with claiming some sort of accolade for portending a disaster which has been sleeping with them for the past three years.

  6. Not to put too fine a point on it, but the sector financial balance approach, which is just an application of double entry book keeping, does not require the private sector to increase its debt growth if the public sector is trying to reduce its debt growth (which it does by reducing the size of fiscal deficits).

    Perhaps a better way to put it: if the government sector decides to reduce the gap between expenditure and income (mostly tax) flows, then some other sector(either domestic households or businesses or foreign trading partners)must increase the gap between expenditures and income IF a decline in nominal national income is to be avoided.

    Assuming no change in the trade balance, nominal GDP won’t grow during a fiscal consolidation unless the domestic private sector reduces its net saving or increases its deficit spending in a more than offsetting fashion.

    The domestic private sector can accomplish this without increasing its debt by a) selling more assets to foreigners, or b) spending more of its cash and near cash holdings on newly produced goods and services. Of course, there is a limit to either of those, and a persistent deficit spending sector eventually has to turn to debt issuance. But strictly speaking, the financial balance approach does not require private debt growth to accelerate when public debt growth is decelerating. I should also mention that if the domestic private sector is defaulting on debt (as households in the US have largely done, rather than net paying down debt), the net change in private sector debt outstanding may be muted in any case.

    In addition, take a look at Flow of Funds data provided by the US
    Federal Reserve. You will find while the household sector debt is still contracting, nonfarm nonfinancial corporate debt growth is up to 4% year/year. This flies right in the face of Richard Koo’s post balance sheet recession private debt minimization story. He does not seem to recognize or at least acknowledge this fact. This is not, at least for the sector as a whole, debt being used to fund capital spending (profits are up 4 times the increase in nonresidential investment spending by the sector, while the latter remains near historical lows as a share of GDP), but rather debt issued to repurchase stocks and boost the share price in the short run. The incentives facing management (and institutional investors) are ultra-myopic, and nothing in the financial reform legislation changed that.

  7. Not to be outdone, the Wayne Swanne and Julia Gillard is trying to engineer an Australian Soverign Debt Crisis.

    I predict a $100B+ deficit next year.