Ecri get ready for more recessions

Get Ready for
More Recessions

June 2010

Today I’d like to share with you what I think is an unusual perspective, rooted in
our group’s longtime focus on business cycle research.

As you know. most analysts are working from pretty much the same toolkit –
using some variation of econometric modeling as the foundation of their
thinking.

But at ECRI we’re not economists. We are, and have been for generations,
students of the business cycle.

To be clear, our analysis is not model-driven.

Rather, it is based on insights into the dynamics of the business cycle.

>>> Let’s begin with a simple question about business cycle basics…

How do you get a recession?

1

A Stylized View of Recession

0

Recessions

©Economic Cycle Research Institute (ECRI)

One way to think about it is that in market economies economic growth cycles up and
down around some sort of long-term trend.

Take a look at this rather simplistic picture, sort of a stylized view of recession which
is meant to make a straightforward point: every time economic growth cycles below
the zero line you get a recession.

Here’s the zero growth rate line
Here’s economic growth cycling up and down around trend growth,
and these red areas are recessions.

So how could we minimize recession frequency, and move towards very long
expansions, preferably without recession for decades?

>>> In principle its quite simple, all we need to do is take the wavy line and lift it up
and we get this…

2

Effect of Higher Trend

0


As you see, the only difference in this chart is that the trend line has been shifted
higher.

And now, economic growth remains above zero.

The poster child for this approach is of course China which has had 10% trend GDP
growth for two decades without a recession, because even while experiencing notable
downswings in economic growth it’s very hard to go from a 10% trend growth rate to
below zero.

We’ve seen similar experiences in India since the mid 1990s and postwar Western
Europe.

>>> With this in mind, let’s move from a stylized view to reality in the United States.

3

Annualized Pace of Growth in U.S. GDP
in Postwar Expansions (%)

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0
49-53 54-57 58-60 61-69 70-73 75-80 80-81 82-90 91-01 01-07


Here’s how things looked BEFORE the Great Recession.

Each of these bars shows trend U.S. GDP growth in successive postwar
expansions.

What you see is that trend growth has been stair-stepping down at least since the
1970s, and the 2001-2007 expansion clearly had the lowest trend GDP growth of
any postwar expansion.

>>> How about another key coincident indicator, employment?

4

Annualized Pace of Growth in U.S. Employment

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
49-53 54-57 58-60 61-69 70-73 75-80 80-81 82-90 91-01 01-07


OKAY

So much for employment.

>>> Let’s broaden this exercise to include all the key coincident indicators.

5

Annualized Pace of Growth in U.S. Coincident Indicators

12

10

8

6

4

2

Industrial Production
0 Mfg &Trade Sales
49-53 54-57 Personal Income
58-60 61-69 GDP
70-73
75-80 80-81 Employment
82-90
91-01
01-07

This may look like a complicated chart, but the point is simple.

It’s not just employment and GDP, which are the first two rows of bars, that have
been stair-stepping down over decades -- it’s also income, sales and industrial
production.

On all counts trend growth in the U.S. has been falling in successive expansions,
and this was clearly the case before the onset of the Great Recession.

In fact, in August 2008 this chart was picked up by Floyd Norris at the NY Times,
but since that was just before the Lehman failure – not a lot of people paid
attention.

So, in the context of raising trend growth to reduce recession frequency,
we’re clearly going the wrong way.

>>> Well, back to square one!!

6


0

Recessions


Looking at the basic challenge, if raising trend growth looks like a non-starter,
how else to reduce recession risk?

>>> How about squishing the wavy line and making it flatter -- like this?

7

Effect of Lower Cyclical Volatility

0


This is the same as the previous picture with one key difference:
the economic growth curve shows less cyclical volatility, so even though trend
growth didn’t go up, economic growth no longer cycles below zero.

This was at the heart of the so-called Great Moderation of business cycles that
gave us long expansions and a couple of mild recessions from the mid 1980s
through 2007.

>>> Again, let’s see how we’re fairing in terms of reality…

8

Volatility of U.S. Economic Growth

16

14

12

10

8

6

4

2

0

Jan-94

Jan-98

Jan-02

Jan-06

Jan-10
Jan-50

Jan-54

Jan-58

Jan-62

Jan-66

Jan-70

Jan-74

Jan-78

Jan-82

Jan-90
Jan-22

Jan-26

Jan-30

Jan-86
Jan-34

Jan-38

Jan-42

Jan-46


Here we have the volatility of U.S. economic growth going back to the early
1920s.

In the first part of the 20th century cyclical volatility was really high, a lot of
boom-bust which quieted down significantly in the postwar period. Then, starting
in the mid 1980s it calmed down even further, and here’s the period many call
the Great Moderation.

After the 2007 - 2009 recession I shouldn’t have to tell anyone that the Great
Moderation seems to be history.

But I know there are still some who believe that we’re going back to the
Great Moderation and that the Great Recession was a one-time anomaly.

>>> To judge if a return to the Great Moderation is likely, we need to understand
why people think it happened in the first place. There’s actually quite a bit of
academic literature aimed at this question and the focus lands on three different
threads of reasoning – 1) better supply chain management,
2) better monetary policy, and 3) luck.

9

Exports as a Percentage of GDP in Asia-Pacific Exports as a Percentage of GDP in Europe
Taiwan 71
63
54

48
Korea
55
47
Germany 42

China
39

31 36
India 23
France 30

15
24

Japan U.K. Italy
7
18
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Exports as a Percentage of GDP in North America
48
44
Canada 40
36
32
28

Mexico 24

20

16

U.S. 12

8
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10


In the context of the supply chain theme, let’s look at exports as a percentage of GDP since
the end of the Cold War. What you find is a remarkable pattern.

In practically every case export dependence has risen dramatically;
Since 1990 in China, Japan and Germany exports as a percentage of GDP have doubled.
In India its tripled, and in the U.S. we’ve seen a 50% rise in exports as a percentage of GDP
up to 12%.
Overall, in the twelve economies shown on these charts, exports as a percentage of GDP
have more than doubled to 35% since 1990.

What unforeseen risks go along with this picture? After all, during the 1990s boom
prominent observers declared that “globalization would help bring about the end of the
business cycle,” as strength in one part of the world balanced out weakness elsewhere.

What they missed has long been called the Bullwhip Effect, where relatively mild
fluctuations in end demand are dramatically amplified up the supply chain, just as a flick of
the wrist sends the tip of a bullwhip flying in a great arc.

Now, because even state of the art supply chain management systems are always blindsided
by cyclical turns in front-end demand, the Bullwhip Effect makes greater export dependence
very dangerous to supplier countries, actually adding to cyclical volatility… which of course,
is the opposite of moderating cyclical volatility (or squishing the wavy line shown a couple
of slides back).

>>> Let’s take a look at how this manifested itself during the recession.

10

Industrial Production in Key Economies (July 2008=100)
& U.S. Great Depression (August 1929=100)
130
China
120
India
110
Taiwan
Korea
100

U.S.
90 Japan
Germany
80

70

60 U.S. in Great Depression
50

40

May-10
Nov-09

Mar-10

Nov-10

May-11

Nov-11
Jul-09

Jul-10

Jul-11
Mar-09

May-09

Sep-09

Jan-10

Sep-10

Mar-11

Sep-11
Nov-08
Jul-08

Sep-08

Jan-11
Jan-09


After two decades of increasing export dependence this is what happened.

In comparison to the decline in U.S. production during the Great Depression
(longer line), look at how production in Japan, Germany, Korea and Taiwan fared
during the 2007-2009 recession.

In each case the downturn in production was much sharper.

This real-world experience is far from the aforementioned theory that better
supply chain management would help smooth out the business cycle.

Given this picture, I don’t know that you can rely on supply chain management to
help resurrect the Great Moderation.

>>> So what about the other argument, which is that monetary policy timing
skills have improved so much that we can reliably pull off soft-landings?

11

Evolution of ECRI’s and Fed’s Views
About Inflation and Growth Risk
25
24 9/08 8/08
23 6/08
22
4/08
21 3/08
20
19
18
17
1/08
9/08

Risk to Growth
Risk to Growth
16 9/08
15
12/07 4/08
14
13
12
3/08 8/08
11
10 1/08
10/07 10/07
10/07 6/08
9
8
9/07 9/07
7
12/07
6
8/07 8/07
5
4
3
Inflation Risk
2


Well, this chart shows ECRI’s interpretation of how the Fed’s assessment of inflation risk and risks
to growth evolved in the lead up to the Lehman crisis. You also see how our own views evolved in
that timeframe.

We tried to make this as unbiased as possible. We based each data point on official Fed statements
on the one hand, and the performance of ECRI’s Weekly Leading Index of economic growth and
the Future Inflation Gauge on the other (which, by the way, are both released publicly).

What this shows is dramatic.

In contrast to a steady and more timely evolution of ECRI’s views whereby recession risk was
increasingly trumping inflation risk, the Fed’s position effectively showed their views flailing back
and forth until they belatedly recognized the reality of recession following the Lehman failure.

It’s actually instructive to look at each of the points in time and understand just how far behind the
curve they were, but I’ll just ask you to think back to June 2008 <POINT TO DATE> when, based
on what the Fed was saying, Fed Funds futures were pricing in 100 basis points of tightening from
2% - 3% by year end.

To be clear, this was when we were already six months into the recession.

But this episode is hardly an exception. Think back a few more years to June of 2003 when the Fed
cut rates to 1% to battle deflation risk. In just a matter of weeks following that cut, GDP growth
was already surging to a 20-year high.

With episodes like these it’s hard to argue that we have good monetary policy timing.

Who knows, they might get their policy timing just right this time around. As the New York State
lottery slogan goes, “Hey, you never know.”

>>>This brings us to the 3rd explanation offered by academics for the Great Moderation, which is
luck

12

Average Percentage of G5 Economies in Business Cycle
Expansions During U.S. Business Cycle Expansions
100%

95%

90%

85%

80%

75%
1956-69 1970-82 1982-90 1991-2003 2003-10


Now, if you look at this chart showing the synchronicity of international expansions,
what jumps out -- as missing -- is the 1990s, which was at the heart of the Great
Moderation.

In essence, during that time the major economies took turns going into recession, with
the English-speaking recession in the early 1990s being followed by recessions in
Japan and continental Europe and so on.

As a result there was significant disinflationary global over capacity that enabled the
Fed to remain relatively loose without a major inflation problem. This was in addition
to capacity unleashed by the end of the Cold War.

What happened for those dozen years was hardly by design, nor was it a lasting
pattern.

Essentially, it was luck.

>>> Let me ask -- are you comfortable counting on a repeat of this sort of good fortune
as it were? If not, we must return to the now familiar slide.

13


0

Recessions


To be clear, we are really talking about higher cyclical volatility, not a return to a
super-mild business cycle.

And remember, we’re also talking of a well-established pattern of lower trend
growth.

This is exactly the opposite of what we’d like to see in the context of this chart.
We’d like to see the trend line rising, but it’s falling.
We’d like to see the wavy line flatten, but instead the swings are bigger.

>>> Still, how well does this chart conform to reality?

In the real world is the length of expansion driven by trend growth and cyclical
volatility as the chart suggests?

14

Estimates of Recession Frequency
* FR
(1973-84)

100
100
* US (1907-33)

90
*
NZ (1966-91)

US (1973-84)
80

Higher percentage of recessions
* SA (1967-93)
KO (1997-09)
70 MX
* * IN US (1946-72)
* *
US (1934-45)

**
(1958-80) GE
CH
*
60

* *
JA (1990-09)
UK (1973-84)
**
SW
TW* NZ
50
(1997-09)
IT *
ES
*(1992-09)

US (1985-09) SA
FR (1985-09)
OS * * AU *
FR (1956-72)
40
* (1994-09)
* *
* TW
(1965-96)
30 IN (1981-09)

*
UK (1985-09) * JA (1954-89)
**
KO (1967-96)*
20 *
CA 9.18
7.27
7.27

ty
CN *

tili
10 5.31

ola
4.58

lv
0 10 4.28
4.28

ica
* UK (1953-72)
4.13
4.13

ycl
0.49 1.77
2.33 2.54
2.62 2.90

rc
3.04 3.08 3.37
Higher trend

e
3.39 3.59
3.59 3.69

gh
rate of grow
4.42 5.02 2.28
2.28

Hi
6.16 8.65
8.65 9.78 th
10.44

Here we pull together the international evidence showing that trend growth and
volatility largely explain the length of expansion.

What you see is a three dimensional regression surface relating trend growth
and cycle volatility on the two horizontal axes, to the vertical axis showing the
percentage of slowdowns that become recessions
The asterisks are the actual percentages, and the dots are the regression
estimates.

So, when you have high cycle volatility and low trend growth you have the most
slowdowns becoming recessions <TOP AREA>

And when you have lower cycle swings and higher trend growth you have more
soft landings without recession <BOTTOM AREA>

>>> Let’s boil this all down to the U.S. experience…

15

Predicted and Actual Lengths of U.S. Expansions (months)

125
'91-'01

'61-'69
100
'82-'90

Actual Length
75
'01-'07

'75-'80
50
'49-'53
'54-'57
'70-'73
25 '58-'60

'80-'81

0
0 25 50 75 100 125
Predicted Length


Here on the horizontal axis we have the predicted length of U.S. expansions based simply on trend growth
and volatility. On the vertical axis you have the actual length of expansion.

You can see there is a pretty good relationship with trend growth and volatility explaining 70% of the
variance in the length of expansions.

So what I’m sharing with you today is much more than theoretical.

The convergence of a pattern of lower and lower trend growth combined with higher cyclical volatility it
just dictates more frequent recessions.
Quite simply, in the coming decade we’re unlikely to see the kind of long expansions that we’ve become
used to since the early 1980s. Rather, we’re likely to see more frequent recessions.

This view is in sharp contrast to the forecasts of most economists and their models, which show a
relatively smooth projection into the future.
Maybe these forecasts show anemic growth with a few bumps and squiggles thrown in, but that is a far
cry from the cyclical instability that we foresee.

Why should anyone care if we’re right? Let me offer a few things to think about:
For policy makers a key takeaway is that the next recession will begin long before the jobless rate is
anywhere near full employment, with the attendant monetary and fiscal policy implications.

For investors, the problem goes further in that recessions are associated with major bear markets. So
more frequent recessions demand the ability to ride the cycle in both directions, not a buy-and-hold
mindset.

Separately, frequent recessions tend to raise the equity risk premium and crunch P/E multiples.
Case in point is the U.S. economy which between 1969 and 1982 saw four recessions in 13 years.
During that time the stock market gyrated quite a bit but ended up where it started, even though
earnings had clearly risen.
Even worse is Japan, which has also seen four recessions since the popping of its asset bubble and the
Nikkei is now about a quarter of its 1989 value, again even though earnings are up.

>>> Which brings me to the worst case scenario…

16

Inflation, Deflation and the Relative Durations
of Expansions and Contractions

4.5
1932-2010 3.5%
3.6%

-0.1
1920-1932 -3.1%
-6.9%

0.6
1896-1920 3.7%
5.1%

-0.2
1864-1896 -2.0%
-3.2%

1.7
1843-1864 2.5%
4.7%

-0.1
1814-1843 -2.8%
-3.1%

1.1
1789-1814 3.0%
3.1%

-8 -6 -4 -2 0 2 4 6


This chart shows alternating inflationary and deflationary ERAS in the U.S. over the last 220
YEARS.

The green and yellow bars represent the average rate of inflation in each era as measured by the
CPI and WPI respectively.

So we’ve had four inflationary and three deflationary eras, each including several business cycles.

The red bars are where things get interesting as they show the average length of expansion
relative to the average length of recession in each of those eras.

When the red bars extend to the right, more time on average is spent in expansion than contraction.
When the red bars extend to the left, more time on average is spent in recession than in expansion.

It is striking that in every era where the economy spent more time in recession it resulted in
sustained deflation.

This worst case scenario, where frequent recessions also mean we’re spending more time in
recession than expansion, is not without precedent. In fact this is the essence of Japan's challenge.

Well, I think I’ve made my case. To wrap up, the business cycle landscape is likely to be quite
different in the coming decade, resulting in a profound shift in the kinds of challenges that decision
makers are likely to face.

17

Ecri get ready for more recessions

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