Monday, March 9, 2009

An L Of A Recession

Wolfgang Munchau in the FT:

An L of a recession – reform is the way out
By Wolfgang Münchau

Published: March 8 2009 18:15 | Last updated: March 8 2009 18:15

The US is dragging its feet over the financial sector. The European Union is doing the same, as well as failing to adopt policies that could shield it from an increasingly probable speculative attack. And judging by the state of preparations, the forthcoming Group of 20 summit is going to be a disaster.

So it looks like it is going to be an L – not a V or a U. I mean an L-shaped recession, one that starts with a steep decline, followed by very low growth for many years. In a V-type recession, the recovery is instant. In a U-type, it comes eventually. My guess is that we are currently somewhere in the middle of the vertical bit of the L, but it is the horizontal bit that is the scariest. History never repeats itself exactly, but we know from economic history that financial crises are surprisingly similar. This looks like Japan all over. Without financial restructuring, the economy is not going to recover. And Japan was lucky. It was surrounded by a booming global economy.

The best way to fight such a disaster is to restructure the banking system and provide short-term economic stimulus through monetary and fiscal policy. Speaking at a recent Aspen Italia conference in Rome, Martin Feldstein, a former economic adviser to Ronald Reagan and president of the National Bureau of Economic Research, estimated that US consumer spending would fall by $500bn (€395m, £355bn) annually, and construction spending by $250bn. Against this combined annual $750bn shortfall, the current stimulus package is woefully inadequate. In other words: we are looking at an L.

An L-shaped recession will make the adjustment of balance sheets even more painful. Unemployment will continue to rise. House prices will keep on falling. US consumers and banks will spend the next five or more years deleveraging, getting their respective balance sheets back in order. In that period, the US current-account deficit will fall sharply, as will that of the UK, Spain and several central and eastern European countries. This process can take a long time, and in an L-shaped recession it takes longer.

But the effect is also brutal on the rest of the world. The fall in current-account deficits will be partially compensated for by lower surpluses from oil and gas exporters, such as Middle Eastern countries and Russia. But the bulk of the adjustment would be borne by the world’s largest exporters: Germany, China and Japan. Globally, current-account deficits and surpluses add up to zero – minus some statistical reporting errors. You can do the maths. If the US stops buying German cars, Germany will eventually stop making them.

If we had a simple U-shaped recession, we would still have a painful recession in Germany and Japan, for example. But under a U-shaped scenario, both countries would be among the first to benefit from the recovery.

In an L-shaped recession, however, recession gives way to depression, despite the fact that both countries thought they had done their “homework”. If nobody can afford to run a large deficit for a long time – which is what an L recession effectively implies – the economic models of Germany and Japan will no longer work. Germany had a current-account surplus of more than 7 per cent last year. It is the world’s largest exporter. Exports constitute about 41 per cent of national gross domestic product – an extraordinary number, given the size of the country.

So what should these countries do? The right policy response would be to reduce the dependency on exports and undertake structural reforms that facilitate the shift towards non-tradable goods. These are not the same type of structural reforms as those of the past, involving cost-cutting and improving competitiveness. This is about flexibility and mobility.

Unfortunately, the opposite is happening. Germany is clinging to its export model like a drug addict. An example is the debate about the future of Opel, the European car manufacturing subsidiary of General Motors. Opel is unlikely to survive without help from the government. The proponents of a state bail-out of Opel argue that the company is systemically relevant. This argument is obviously wrong. There can be systemically relevant banks, but there can be no systemically relevant carmakers. But the answer is also revealing. What it means is that Opel is systemically relevant for the country’s export-oriented model. The bail-out adherents are clinging to an industrial structure that has no hope of survival in an L-shaped world.

To her credit, Angela Merkel, the German chancellor, seems reluctant to agree to the bail-out, as is her party. But pre-election politics will make a bail-out of some sort likely. It is terrible economics. The problem is not even the waste of taxpayers’ money. Combined with French car subsidies, such a decision will contribute to massive overcapacity in the sector and will slow down the economy’s adjustment to the export shock.

We are nowhere near a solution to the crisis. After committing errors of omission, global leaders are now producing errors of commission. The Americans dream about a return to a world of credit finance consumption while the Germans dream about assembly lines. In an L-shaped world, these are nightmares.

No comments: