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The signs don’t point to a typical recovery

The U.S. economy has recently shown signs of improvement but many economists, who were caught off guard by the downturn's brutality, are bracing for head winds that could cause a weak recovery.
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The wounded U.S. economy has shown signs of improvement in recent weeks. But many economists, who were caught off guard by the brutality of the downturn, are accentuating the negative, bracing for head winds that could cause the recovery to be weak.

Huge swaths of the financial system have been damaged, which could lock consumers and businesses out of loans for years to come. American families are saving more and relying less on borrowed money. In this global recession, no part of the world appears poised to lead a buoyant recovery. And the U.S. government's aggressive stimulus efforts -- including special Federal Reserve lending programs and full-throttle government spending -- may need to wind down before the economy returns to solid footing.

Typically, a deep downturn is followed by a robust recovery, as happened with the steep recession of 1981-82, the most severe since World War II, which was followed by explosive growth through the rest of the decade. Many -- but not all -- of the world's top economists doubt that a boom will follow this time.

"Traditional economic models are built like a rubber band: You pull it hard and it will snap back," said Martin Neil Baily, an economist at the Brookings Institution. "I find it hard to see where that will come from in this case."

In other words, the downturn may be so severe, global and transformative that this time, the rubber band popped.

What's different now? This downturn was caused by a breakdown in the financial system, and in the wake of a massive housing and credit bubble.

Historically, recessions have come about when businesses over-invested or when the Federal Reserve aggressively raised interest rates. Once business inventories and staffing levels correct themselves, or once the Fed cuts rates, growth resumes.

Downturns caused by financial crises play out differently. The machinery of the financial system grinds to a halt; people cannot get credit to buy things and businesses cannot borrow money to expand.

According to an analysis of 14 financial crises around the world by economists Carmen M. Reinhart and Kenneth Rogoff, the unemployment rate rises an average of seven percentage points in a downturn (this one has increased the U.S. jobless rate by only 4.7 percentage points), and the crisis lasts an average of 4.8 years (this one is at the two-year point).

Growth spurts can emerge, and it appears increasingly likely that the U.S. economy will grow at a solid pace in the second half of the year, as companies restock depleted inventories. But it is unclear what would come after that, given the ongoing restrictions on credit.

U.S. banks have sustained massive losses already, and a wave of soured commercial real estate loans threatens to further limit their ability to lend in the year ahead. A bigger problem looms outside of banks -- in credit markets, which account for vast chunks of mortgage lending, consumer loans and commercial real estate loans. This shadow banking system remains dysfunctional -- notwithstanding a slew of programs the Fed put in place to get it going again -- and no one is sure when or whether it will recover.

All that makes it more expensive for people or businesses to borrow money -- if they can get a loan at all -- which could serve as a powerful brake on any recovery.

"Credit fuels housing. It fuels consumer durable goods. It fuels business investment. It's in every part of the economy," said Reinhart, an economist at the University of Maryland. "Credit makes recessions after a financial crisis longer, and all the signs are that [it] is happening this time as well."

Credit history
A related head wind comes from American consumers. The financial crisis and recession are reversing a 30-year trend carrying Americans toward a high point in debt. The ratio of consumer debt to the nation's total economic output rose to 97 percent in the first quarter of this year from 45 percent in 1975.

Currently, Americans are saving more and paying down debt; the savings rate was 1.2 percent of disposable income in early 2008. By the second quarter of this year, that rose to 5.2 percent.

"The household sector has never been so stressed," said RGE Monitor Chairman Nouriel Roubini, who predicted the crisis and recession. "Savings has to go much higher, and that is going to slow growth of consumption even once incomes start growing."

Every dollar that Americans save is one fewer dollar for consumption, which means less economic output. When the savings rate goes up by a percentage point, spending decreases by more than $100 billion, according to the McKinsey Global Institute.

"What held Japan back in the 1990s was that firms there wanted to pay down debts and so they saved more," said Simon Johnson, an MIT professor and former chief economist of the International Monetary Fund. (Johnson also co-writes The Hearing, a weekly column on "Are we going through the same sort of adjustment on the consumer side? The answer is probably yes."

When nations in financial crisis have defied the trend and experienced a rapid recovery, it was often because of strength elsewhere in the world. East Asian economies rebounded nicely from their 1997-98 financial crisis, for example, on the back of exports to the United States -- which had a booming economy at the time.

But what market today would clamor for U.S. products?

"Everybody in the world is experiencing the same constraints on credit and on consumption," said Mark Gertler, an economist at New York University.

In the adjustment that appears to be taking place, the United States is reshuffling the relative importance of different parts of the economy: reducing consumer spending and investment in housing while increasing exports and business investment.

The cutback in consumer spending and drop in residential investment are well underway -- and may be nearly done. The problem is on the positive side of the ledger. Exports are down 16 percent in the past year as global trade has plummeted, and business investment is down 20 percent as corporate America has become more apprehensive and as access to credit has diminished.

"Ultimately, we would like to see the U.S. have a more export-led growth path. But with the rest of the world weak, that will be hard to achieve," said Baily, of the Brookings Institution.

A policy of precision
Government policy, which is bolstering the economy now, could prove to be another head wind in the years ahead.

The Federal Reserve has cut its target for short-term interest rates to almost zero and said it would leave them there for an "extended period." In addition, it is buying nearly $1.5 trillion in mortgage-related securities to push down long-term interest rates and has introduced programs to encourage lending.

To prevent a bout of high inflation in years ahead, the central bank eventually will have to draw down those programs and raise interest rates. When that day comes, it could pose a hurdle to recovery.

Fed leaders hope to exit at the precise time, only until the economy is on solid enough footing to grow even as the Fed raises rates. But if inflation expectations get out of hand, they could be forced to move sooner.

The course of fiscal policy is even more uncertain. The budget deficit is set to be about 12 percent of gross domestic product this year, as tax revenue has plummeted and as the government has spent widely to stimulate the economy.

The Obama administration has indicated that it wants to lower the deficit to around 3 percent of the GDP within years. If all goes well, the transition would be relatively painless -- a growing economy would boost tax revenue, and the stimulus package and financial bailouts would expire naturally.

But if the economy remains weak, the administration and Congress may face more difficult decisions and have less room to maneuver.

In this recession, U.S. leaders have had ample flexibility to spend as they see fit, since global investors have been eager to lend to the nation because of the perceived safety of its debt. An extended recession or weak recovery, however, could quash that confidence.

"If the recovery is a disappointing one, you could face a situation where you have to get the fiscal house in order before the economy has improved substantially," Reinhart said. "We are piling on debt at an incredible clip, but we have been able to because in times of stress there is a flight to Treasurys [Treasury bonds]. But that doesn't negate the fact that, down the road, we need a substantial fiscal adjustment."

Long slog or snapback?
Although widely held among top economists, the idea that all these head winds will weaken the recovery is not universal. The U.S. economy has proved resilient in the past, emerging out of deep downturns with force.

"There is only one reliable regularity in business cycle history in the United States," said Michael Mussa, a senior fellow at the Peter G. Peterson Institute for International Economics, in a presentation earlier this year. "Deep recessions are followed by steep recoveries and economic forecasts almost never take account of this regularity."

At the core of Mussa's argument that the recovery will be shaped like a "V," with a sharp snapback, rather than a "U," is a view that others put too much emphasis on the need for the system to stabilize.

In a recent interview, Mussa noted that the U.S. economy grew robustly in the mid-1980s despite the failure of savings and loans. "Korea experienced a spectacular recovery following the market collapse of 1997-98, even though the domestic financial system was a mess," he said. Similar story with Argentina, where the financial system collapsed in 2001-02, followed by five years of strong recovery.

Mussa, a former research director at the IMF, imagines the U.S. economy growing 6 to 7 percent over the coming year, as businesses rebuild inventories and as the housing and auto sectors edge nearer to their long-term potential (though still remaining far below their levels in boom years).

"The historical record is that when you have deep recessions, the recovery tends to be very sharp, with growth well in excess of the trend," Mussa said.

Even skeptics of that idea -- the crowd that thinks a long slog out of the economic wilderness is more likely -- are hoping Mussa is right.

"The honest truth is there's incredible uncertainty in the forecast right now," said Gertler, of New York University. "Recessions are periods where the negative surprises outweigh the positive surprises. We're overdue for some more positive surprises now."

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