The Current Economic Cycle: U, V, W or Zigzag?

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Are we coming out of the recession, slowly but surely, and ascending to sustainable economic growth? Martin Feldstein, a senior professor of economics at Harvard, says no: "I think we’re going to see a temporary substantial improvement," Feldstein stated, adding. "I emphasize the words temporary and substantial." Feldstein was formerly head of the National Bureau of Economic Research, a private research group that analyzes economic growth, including the timing of recessions and recoveries. Feldstein predicts that the domestic economy will contract sharply again in 2010. He foresees not a V-shape--into recession and then out--or even a “beautiful, symmetrical W,” but more of a seesaw pattern. Source: Bloomberg Radio; see Feldstein's Remarks.

Feldstein’s “seesaw” metaphor is particularly striking because the consensus calls for a gradual U-shaped recession to recovery cycle. As the consensus of blue chip economists and forecasters is often dead wrong, it is prudent to consider alternatives. One factor that might support Feldstein’s remarks: money supply, as influenced by federal spending.

The fiscal stimulus package so far consists of three parts: immediate, intermediate and long-term. Immediate stimuli included the $400 individual tax credit, which has passed through the system already. The package also included improvements in unemployment benefits. Stimuli of a more intermediate nature included support for state Medicaid plans, a tax credit for first time home buyers, tax incentives for new car purchases and trade-in of “clunkers,” tax incentives for modest income families to weatherize their homes, and temporary extension of COBRA health coverage benefits beyond statutory limits.

Long-term stimuli include: over $100 billion for education and job training; $27.5 billion for highways and bridges; $11 billion to improve the nation’s electricity grid; and $7 billion for broadband development in rural areas. Source: The Stimulus Plan: How to Spend $787 Billion - The New York Times. These projects will take many years to design, approve and build or implement. However laudable some of these purposes are, most of the money may not enter the economy until after the recession has ended, and the spending may fuel future inflationary pressures. Such are the pitfalls of quasi-Keynesian economics as proposed by the Executive Branch and massaged in Congress.

In the meantime, cutbacks in aid to states and cities by the federal government—enacted as part of a political compromise with moderate Republicans—are starting to counteract the federal stimulus.

An unknown factor is the willingness of commercial banks to increase now depressed levels of commercial and consumer lending. Commercial banks and financial institutions so far have used most of their TARP funds to improve their balance sheets rather than to re-circulate the money to borrowers.

Consider also credit creation outside of the commercial bank balance sheets. As economist and independent trader Gary Evans has often reminded me, the overall shrinkage of this “shadow banking system” is severely contractionary. The shadow financial system includes all sorts of institutions and processes that put investors and borrowers together, other than by bank lending. It includes: investment banks; the corporate bond and commercial paper markets; conduits for mortgages and corporate bonds; off balance sheet structured investment vehicles (SIV’s); securitizations of assets [including mortgage-backed passthrough securties (MBS), collateralized debt obligations (CDO's), collateralized loan obligations (CLO's); collateralized mortgage obligations(CMO's); and asset-backed securities (ABS) such as credit cards and utility billings]; monoline insurance companies; over the counter swaps and options; bank loan funds; insurance company funding schemes, including fixed and variable annuities and guaranteed investment contracts; and non-bank finance companies.

Another unknown factor is international trade. We are embedded in an increasingly global economy, and our fortunes are tied to the problems and opportunities of other economies, many of whom are still mired in recession.

Yet another unknown factor is the ability and willingness of the Fed to maintain an unprecedented accommodative stance, with nominal rates for Federal Funds targeted between 0% and ¼%. Four factors that could tilt the Fed toward tightening would be sharp rises in the consumer price index, labor market scarcities, severe weakness in the US dollar or a marked steepening of the yield curve (implying rising long-term inflationary expectations among bond investors).

An implication of Professor Feldstein’s forecast is that the current round of economic stimulus may not be enough to lead to sustained growth. Setbacks would lead to pressure for further fiscal stimulus, lower tax receipts and even greater federal deficit spending. Such conditions could in turn raise the cost of cost of raising capital privately, which would retard corporate recovery.

Shakespeare wrote that the “course of love never did run smooth”, and the same is probably true for the current economic cycle. In this recovery, we may zig and zag more than we zoom.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions: e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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