The shape of things to come?

by Jérémie Cohen-Setton on 2nd October 2009

What’s at stake: After being downgraded for almost a year and a half, growth forecasts for the world economy have become more stable since the first quarter of 2009. Recent updates by the OECD and the IMF for the third and fourth quarters of 2009 have been revised upwards - in some cases significantly. The IMF has just published its latest forecast for the global economy, the World Economic Outlook, which says that although the global recession is ending, a subdued recovery lies ahead.

Ron Derven of the Atlanta Fed's macroblog says that although the majority of economists believe the recession is ending what remains interesting is the range of disagreement about just how fast the recovery will be. Take the third quarter of 2009 for the US, there is a 3 percentage point difference between the 10 most optimistic and the 10 most pessimistic forecasters. Most interesting is the fact that some collection of these economists are, in any given quarter, guessing that growth will not break a 2 percent annual pace before we exit 2010.

Olivier Blanchard says that the world economy will likely return to its past growth rate, but the period of above-average growth, characteristic of normal recoveries, may be short-lived or nonexistent. The progress we have observed can be explained by various factors including the re-building of stocks (company inventories) and economic policy measures to support economies, rather than on strong private consumption and fixed investment spending. But the effects will not last long as the fiscal stimuli will have to be phased out and inventory adjustment will naturally come to an end.

Michel Mussa say that the recovery will surpass almost all current forecasts on the upside and will once again illustrate that steep recoveries tend to follow deep recessions. While most economic forecasters expect a tepid recovery, and some fear a "double dip" in which economies fall back into recession at an early stage, Mussa expects a V-shaped recovery to be the most likely course. Olivier Blanchard says that will all due respect to his predecessor, he has no clue where this rule of thumb comes from. Willem Buiter says that it is called the Victor Zarnovitz law, but that it is unlikely to be relevant for a deeply financially challenged economy like the US, where massive financial damage was done before the recession.

Janet Yellen, San Francisco’s Fed chief, says that she expects the recovery to be tepid and that the gradual expansion gathering steam will remain vulnerable to shocks. The biggest source of expansion in the second half of this year will come from a diminished pace of inventory liquidation by manufacturers, wholesalers, and retailers. Although, typically short-lived, such a boost can actually be quite important in getting things going for a while. Other sectors then need to grow to sustain it. But the fact that the largest sector of the economy – consumer spending – is likely to be lacklustre implies a less-than-robust expansion.

Antonio Fatas says that how strong the economic recovery will be depends on whether we believe that output will quickly return back to its trend. Usually, the output gap becomes negative (output is below potential) during recessions and the recovery brings output back to its trend. But, as argued in Chapter 4 of the WEO, there is, however, evidence that output does not always return to its trend after a deep crisis. Banking/financial crises, in particular, tend to leave a permanent (or at least a medium-term) scar on the economy. From that graph, it looks as though the Fund thinks that the world economy will now grow on a path, 10 per cent lower in perpetuity, than the path it expected in April 2007.

Mohamed El-Erian says that markets aren’t being realistic. Today’s markets have priced in vigorous growth for 2010. Valuations assume companies will be able robustly to grow earnings through higher revenues, not renewed reliance on the cost reductions that have propelled earnings in the past six months. But as Mervyn King said last month, “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.” Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matters today.

Willem Buiter says that although it is difficult to forecast the recovery with any degree of precision, it is possible to make the following statement: The notion of a strong dollar and a strong US economic recovery are inconsistent. The US dollar will have to depreciate, if a long spell of over-capacity, high unemployment and low growth is to be avoided, but it is unlikely to weaken substantially, because the euro, the yen and sterling, are if anything overvalued against the dollar and emerging countries will not allow their currencies to appreciate sufficiently.

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