The Shape Of Things to Come

Economic recovery means government spending restraints and higher taxes.

Listener: 21 November, 2009.

Keywords: Macroeconomics & Money;

In Through the Looking Glass, Humpty Dumpty warns us to be careful with the meaning of words. So what to call a world economy generally turning to custard? No one wanted to call it a “depression” because of the overtones of the Great Depression of the 1930s. The “global financial crisis” describes neutrally what caused the custard, but not its course. Commentators hit on the term “recession”.

Recession does not have a precise meaning in formal economics but usually refers to that phase in the business cycle between the boom and the trough, when economic activity does not grow as fast as usual and may even contract. In the US, a recession is usually said to occur when GDP (total market activity) declines for two successive quarters. Normally the economy rebounds so quickly – the so-called V-shaped recovery – that not a lot of attention is given to the trough phase before the rebound. If the recovery phase of the business cycle is slower, but “normal”, it might be called U-shaped.

Nobody seems to think the world is getting a V-shaped recovery – although some countries are, especially China (and, hence, Australia). Optimists think the general recovery will be U-shaped, although there is a fear it may be W-shaped: a recessionary downswing, followed by a short recovery and then another downswing. If so, we would be some distance off a ?prolonged recovery.

This view arises from a belief that the fiscal injection (more government spending and lower taxes) – especially by the Americans – has been enough to prevent a slump into a depression, but has been insufficient to lift the economy onto a sustainable growth path. The gloomier among us think such fiscal injections are not sustainable without generating inflation. Even if economic activities bottom out, the economy may not grow fast enough, and other important indicators of poor economic performance – unemployment, company closures and mortgage foreclosures – would continue to rise; these indicators do not turn around until well into the recovery phase of the business cycle.

If the recovery is very weak, the economy runs along in a way sometimes described as L-shaped. It can last quite a while; the Rogernomics Recession ran about seven years (longer than the Great Depression, but not as deep), and the Long Depression of the 1880s almost 17 years (but also shallower than the 1930s). Notice that “recession” and “depression” in the previous sentence are not simply referring to the downswing but also to the trough and the early part of the recovery.

The claim that New Zealand’s recession has ended depends upon minuscule growth in a single quarter of GDP, a statistic subject to measurement error. Many will continue to suffer as unemployment, mortgage defaults and business collapses continue to rise. Possibly there may be only a breather before there is a second downswing into that double-dipper W.

The global financial crisis may be over – regulators seem confident the big banks are largely sound (that includes New Zealand’s) – but there may be more failures in the secondary banking sector. The New Zealand Treasury has set aside a substantial $800 million in case it is called upon to fund your guaranteed deposits in other financial institutions.

The international bankers seem to think things are back to normal and have gone back to paying themselves extravagant bonuses. Having transferred the failures of their excesses to the taxpayer, they think they can return to the excesses.

Suppose we are in a recovery phase that will start off slowly and quicken – U-shaped, as opposed to W- or L-shaped. It still won’t be easy. Not only will lay-offs continue for some time, but floating-rate mortgage holders may find their interest rates increasing – perhaps to above 8% – as the world monetary authorities, of which our Reserve Bank is part, attempt to mop up the liquidity they have been injecting.

Along with the US and Britain, New Zealand is among the economies where the fiscal injections are excessive and will have to be restrained back to a sustainable path. In plain English that means more vigorous government spending restraints, curbs and, even, higher taxes.