Possibility of an L-shaped recession

  • Business
  • Saturday, 18 Jul 2009

MANY arguments and disagreements have been triggered by a simple discussion on the current economic recovery status.

This is truly exciting times given the conflicting signals that we are receiving on a daily basis. The IMF has declared that the worst is over. Yes, as we read further into the comments, it cautioned about the stabilisation being uneven and that recovery is still expected to be sluggish.

After last week’s article, I received numerous e-mails, and even had a very interesting face-to-face discussion on the shape of today’s economic recovery.

Some had argued that a V-shaped recovery is still possible – just look at China or Singapore when recent data suggests that recession may be over.

Yet there are others who argued that the worst may be around the bend – Jim Rogers thinks that there will be a currency crisis.

I had a chat with a certain Mr P. His basic conclusion was that it would not be a U-shaped but a W-shaped recovery at best. And whilst on the alphabetical discussion, he threw another scenario into the fray – the “L-shaped recession”.

I have heard and read about this L-shaped recession idea, but had personally refused to entertain the thought. Perhaps, I can be accused of being an optimist, partly because I strongly believe in the ability of the human spirit to rebound and not be stuck in a “rut”.

However, in the long discussion with Mr P, he voiced valid concerns that the current green shoots might be a mirage.

An L-shaped recession is very serious indeed. For U, V or W – the end point is always an uptick. But for an L, the horizontal line can stretch on quite a bit! It pretty much means that the current situation of slow or negative growth may persist over the forseeable future, which could mean at least 3-5 years!

Amongst developed countries, there’s possibly only one such example of a “L” shaped economy – Japan.

The ageing society is very saving oriented despite deposits interest rate having been effectively zero.

Systematically, Japan had suffered low growth with a deflationary or very low inflation environment over pro-longed periods.

Deflation is Japan’s bane, as basically it means that things get cheaper over time. As opposed to inflation, where value of money is eroded over time, in this case, money gets more valuable.

Sound like a good situation to be in, right? No! Deflation is a poison to economic growth because one consequence is that spending is muted. After all, why would you want to spend today, if it would cost you less to buy the same thing in the future?

That is the underlying dynamics in a simplified form. Consumer and corporate spending are key drivers of the economy, so when collectively, the society is not spending, the economy comes to a halt.

But are we talking about deflation in this round of economic recession? Depending on who you speak to, you might get two drastically different opinions.

On one hand, a group of people are talking about a systemic and fundamental de-leveraging of economies.

On the other hand, there is another group who is worried that current liquidity abundance can lead to another round of inflationary pressures.

The former is premised on the acknowledgement that past sins must now be repaid in full. They are referring to a generation of people who had been spending in anticipation of future wealth.

In particular reference to the US, which is the single biggest economy in the world, the savings rates before the onset of this crisis was negative! Yes, as a whole the Americans spent more than they earned. With this crisis, the availability of loose credit has been curtailed, jobs have been lost and home value has collapsed.

There is little opportunity to rely on future “wealth” now. De-leveraging must happen in such environment. But collective de-leveraging implies the further reduction of spending which reduces business turnovers that will lead to weaker economies.

This is not the end of the argument. Given that unemployment and that asset deflation potentially have some way more to go before the turn around, the economy may experience another shock that can further affect other loans beyond mortgage, e.g. credit cards, car loans etc.

That could further weaken the vulnerable financial system, thus resulting in another round of crisis.

And to reinforce the argument, euro zone which is also one of the largest collective economies in the world, is also continuing to suffer from economic weakness.

Not to forget the risks of a currency crisis given the heavy borrowings of developed nations.

The latter group, who fear inflationary pressures, are however highlighting the low interest rates and the pump priming by governments as the roots of the causes.

Collectively, governments globally have done a few things.

They have increased their spending which offset somewhat the contracted consumer and corporate spending.

They have stimulus packages to encourage private spending. They have injected abundance of liquidity into the banking system. They are doing all they can to halt the economic contraction.

These people make reference to the green shoots and say that government should pro-actively pull back liquidity and increase interest rates when things are looking better.

Otherwise, we might have a run-away inflationary situation. They appropriately highlighted that the effects of pump priming takes time to be felt and as such, one can’t wait till there are concrete signs of inflation before pulling the plug. Then it might be too late.

Rightly or wrongly, they also pointed out how Alan Greenspan had kept rates too low in the early 2000s, thus contributing to today’s woes.

In fact, the equity market rally in the last few months was highlighted as a sign that speculative liquidity can have adverse inflationary effects if not reined in promptly.

I can certainly see the merits to both sides of the argument. Whether we end up in a muted growth scenario like a L shaped or rebound into an inflationary fiery, it depends heavily on what our leaders have done and what they continue to do in the current phase.

At the moment, we are clearly not out of the woods yet. But we are certainly not in dire straits like we were in March 2009, when well-known global financial companies were expected to be nationalised.

It certainly is pre-mature to let our guards down now and rejoice. I think that the economies have just been resuscitated after it went flat-liner. But the pulses are still weak and the breathing shallow.

Personally I believe governments, economists and businessmen alike are watching this very carefully and would be on the standby to inject another round of stimulus resuscitation to prevent the economy from going back to flat-liner.

For the time being, I definitely would continue to put the economy on life support and in intensive care for now!

Whatever the shape, I feel that economies will recover. And in the recovery, I can almost say that the balance of power will be shifted towards Asia and Asian economies.

So we should watch this space closely. In crisis, opportunities will surface.

Such opportunities may very well be exactly where we are.

·Tay is senior vice-president and senior head of UOB’s personal financial services division.

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