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Tuesday, April 08, 2008 2:09 AM

Case for an "L" Shaped Recession

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Now that it's clear we are in a recession, the question has arisen as to what shape it will take: "V", "U", "L", or "W".

Nouriel Roubini proposed the question in The US Recession: V or U or W or L-Shaped? and came up with "U". Let's take a look.

Now that there is no doubt that the US is experiencing a recession the debate is moving towards the length, size and depth of such a recession. Will it be a short and shallow recession or a longer and deeper one?

The current new consensus among macro forecasters and Wall Street firms is that the recession will be V-shaped, i.e. be short and shallow.

My view is closer to a U-shaped recession as I expect that the economic contraction will last at least 12 months and possibly as long as 18 months through the middle of 2009. This view is based on the fact that the last two recessions – in 1990-91 and 2001 – lasted 8 months each and today the macro and financial conditions are worse – relative to those two previous recessions - in at least three dimensions:

1. We are experiencing the worst US housing recession since the Great Depression and this housing recession is nowhere near bottoming out. ...

2. In 2001 it was the corporate sector (10% of GDP or real investment) to be in trouble. Today it is the household sector (70% of GDP in private consumption) to be in trouble. ...

3. The US is experiencing its most severe financial crisis since the Great Depression. This is not just a subprime meltdown. Losses are spreading to near prime and prime mortgages; they are spreading to commercial real estate mortgages. They will spread to unsecured consumer credit in a recession (credit cards, auto loans, student loans). The losses are now increasing in the leveraged loans that financed reckless and excessively debt-burdened LBOs; they are spreading to muni bonds as default rates among municipalities will rise in a housing-led recession; they are spreading to industrial and commercial loans. And they will soon spread to corporate bonds – and thus to the CDS market – as default rates – close to 0% in 2006-2007 will spike above 10% during a recession. ....

Finally, could the US experience an L-shaped recession, i.e. a protracted period of economic stagnation like the one experienced by Japan in the 1990s after the bursting of its housing and equity bubble? My view is that a protracted economic stagnation – bordering on an economic depression – is unlikely in the case of the US as the policy response of the US is already more aggressive than the one of Japan. Japan waited almost two years after the bursting of its bubble to ease monetary policy; and it waited two years before providing fiscal stimulus. In the US, instead, both monetary and fiscal stimulus have started in earnest early on. Also Japanese postponed the necessary corporate and banking restructuring for years keeping alive zombie firms and zombie banks via inappropriate forms of forbearance. In the US both private and especially public efforts to restructure the impaired assets and firms will start faster and more aggressively. Thus the risk of a decade-long economic stagnation is quite limited so far.
Those are significant, yet incomplete snips. I recommend reading the entire article. Calculated Risk discussed the shape in Roubini on Shape of Recession and concluded:
My major area of disagreement with Roubini is the severity of the recession. I also think the recession will linger (at least the effects of the recession). And a double dip is very possible.

But to say this will be the "most severe recession" in decades suggests job losses - and a corresponding increase in the unemployment rate - that I don't see on the horizon. The good news is that manufacturing employment is holding up better than usual in a recession due to a combination of a weak dollar (strong exports) and relatively strong global growth. This doesn't mean the recession won't be painful for many - I think it will be. And the recession could be severe if manufacturing contracts sharply (probably due to a global recession), but I think this is less likely than Roubini.
This is an interesting discussion. Without proclaiming a shape, Calculated Risk concentrated on the severity side, primarily based on jobs.

The "W" talk seems based on the idea that there may be a brief rebound in the second half based on the Bush economic stimulus plan. That stimulus plan will fail but perhaps it temporarily pulls the US out of recession for one or two quarters.

More likely to me is something like an "L" or a "WW" kind of scenario with the U.S. slipping in and out of recession for a prolonged period of time, perhaps 3-4 years or more.

Roubini nailed three reasons for a severe recession but dismisses "L" because the U.S. acted faster than Japan. I do not buy that argument for these reasons.
  • U.S consumers are in much worse debt shape than Japan.
  • There is global wage arbitrage now that did not exist to a huge degree in the mid to late 1990's. Even white collar jobs are increasingly at risk.
  • The savings rate in the US is in far more need of repair than what Japan faced. This will be a huge drag on future spending and slow any recovery attempts.
  • Japan faced a huge asset bubble (valuation) problem. The US faces both a valuation problem (what debt on the books is worth) and a rampant overcapacity issue as well.
  • Japan had an internet boom to help smooth things out. There is no tech revolution on the horizon that will provide a huge source of jobs.
Property & Portfolio Research calculates that demand justified 36% of the new space built last year and will support 15.7% of the space slated to be completed this year. See Commercial Slowdown A Disaster For Jobs for more on how overbuilt commercial real estate is.

There will be numerous small or regional bank failures coming from the commercial real estate crash. We will not need strip malls for years to come. It will take four years to work off the inventory of houses. And that assumes builders further cut back new projects.

In a statement I have been repeating for a year, there is no need for more Wal-Marts (WMT), Pizza Huts (YUM), Targets (TGT), nail salons or strip malls. Indeed, major retailers all are dramatically scaling back plans right now. Simply put, there is no source of new jobs heading forward, even as layoffs pick up steam. Unemployment will soar and that will further depress housing by creating more foreclosures and thus more inventory.

These factors will drag out the recovery process no matter what Bernanke does.

There is also the issue of $500 trillion dollars worth of derivatives, $45 trillion of which are credit defaults swaps with enormous counterparty risk. Japan did not face this issue at all. Derivatives are in uncharted territory.

The Trillion Dollar Meltdown

Bloomberg is writing Brace for $1 Trillion Writedown of `Yertle the Turtle' Debt.
$1 trillion is the amount of defaults and writedowns Americans will likely witness before they emerge at the far side of the bursting credit bubble, estimates Charles R. Morris in his shrewd primer, "The Trillion Dollar Meltdown." That calculation assumes an orderly unwinding, which he doesn't expect.

Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps, Morris says. The notional value for those swaps, which are meant to insure bondholders against default, covered about $45 trillion in portfolios as of mid-2007, up from some $1 trillion in 2001, he writes.

Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that "most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees," he writes.

Morris sketches a scenario in which hedge fund counterparty defaults would ripple through default swap markets, triggering writedowns of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer "an utter thrombosis," he says, making the subprime crisis "look like a walk in the park."

What he fears is that the U.S. will instead follow the Japanese precedent, seeking to "downplay and to conceal. Continuing on that course will be a path to disaster."
In a book review of Charles Morris: “The Trillion Dollar Meltdown” Roubini had this to say:
So the estimate of $1 trillion of losses that I first presented in February has now become conventional wisdom as George Magnus, Martin Wolf, Goldman Sachs and now Charles Morris are all coming up with a similar estimate.
Liquidationist Thesis

The latest Credit Bubble Bulletin, by Doug Noland is a good one: Economic Structure and the "Liquidationist Thesis".
It is my view that our economy will require a massive reallocation of resources. We will be forced to create much less non-productive (especially mortgage and asset-based) Credit in the Financial Sphere, while producing huge additional quantities of tradable goods in the Economic Sphere. In our expansive “services” sector, there will no choice but to “liquidate” labor and redirect its efforts. Throughout finance, there will be no alternative than to “liquidate” bad debt, labor and insolvent institutions – again in the name of a necessary redirecting of resources. After an unnecessarily protracted boom, there will be scores of enterprises that will prove uneconomic in the new financial and economic backdrop. “Liquidation” will be unavoidable, policymaker hopes and dreams notwithstanding.

From this evening's vantage point, recent extraordinary government measures to “back” U.S. finance appear likely to delay the adjustment process – what I will be referring to as a “depression.” This reprieve, however, comes with a cost. It will ensure significantly greater damage to the core of our monetary system, as well as requiring a more onerous real economy “liquidation” with the inevitable onset of the more serious phase of the unfolding crisis.
Delayed Is Prolonged

I buy Noland's Liquidationist Thesis. However, it should be clear the Fed will fight liquidation tooth and nail. Such actions by the Fed will prolong the agony. That seems to be the conclusion of Morris as well.

Noland used one of the "D" words in his thesis: "depression". Without a definition it's hard to come to a definitive conclusion as to whether that is where we are headed.

What's not debatable is what will happen if $1 trillion is written off. And that is the other "D" word: "deflation". A $1 trillion debt writeoff can hardly mean anything else. Furthermore, a $1 trillion writeoff will affect a whopping $10 trillion in future lending.

If the Fed and Congress drag this out, which at this point seems likely, we will see a severe "L" or "WW" shaped recession playing out over several (or more) years.

Mike "Mish" Shedlock
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