The US Recession: V or U or W or L-Shaped?

Nouriel Roubini, 04/07/08

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?

In principle the US recession could end up being V or U or 

W or L-Shaped. Which one of these four scenarios is

most likely?

Let us analyze this question in more detail…

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. Most analysts argue

that GDP will contract in Q1 and Q2 and recover in the

second half of 2008.

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:

We are experiencing the worst US housing recession 

since the Great Depression and this housing recession is

nowhere near bottoming out. Housing starts have fallen

50% but new home sales have fallen more than 60% thus

creating a glut of new –and existing homes- that is

pushing home prices sharply down, already 10% so far

and another 10% in 2008. With home prices down 10%

$2 trillion of home wealth is already wiped out and 6

million households have negative equity and may walk

away from their homes; with home prices falling by year

end 20% $4 trillion of housing wealth will be destroyed

and 16 million households will be in negative wealth

territory. And by 2010 the cumulative fall in home prices

will be close to 30% with $6 trillion of home equity

destroyed and 21 million households (40% of the 51

million having a mortgage being underwater). Potential

credit losses from households walking away from their

homes (“jingle mail”) could be $1 trillion or more, thus

wiping out most of the capital of the US financial system. 

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. The US consumer is shopped out, saving-less,

debt burdened (debt being 136% of income) and buffeted

by many negative shocks: falling home prices, falling

home equity withdrawal, falling stock prices, rising debt

servicing ratios, credit crunch in mortgages and –

increasingly – consumer credit, rising oil and gasoline

prices, falling employment (now for three months in a

row), rising inflation eroding real incomes, sluggish real

income growth.

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-

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. I

estimate that financial losses outside residential

mortgages (and related RMBS and CDOs) will be at least

$700 billion (an estimate close to a similar one presented

by Goldman Sachs). Thus, total financial losses –

including possibly a $1 trillion in mortgages and related

securitized products - could be as high as $1.7 trillion.

Thus, given the worst US housing recession since the

Great Depression, a US consumer who is on the ropes

and at its tipping point and a most severe financial crisis

and credit crunch it is delusional to argue that the current

recession will be milder (6 months) than the mild and

shallow recessions (lasting 8 months) that the US

experienced in the last two times.

Could the US recession end up being W-shaped, i.e. a

double-dip recession? This view is presented by those

who argue that the recent fiscal stimulus – that will

provide a tax rebate to US households in May-June –

could lead - after negative growth in Q1 and Q2 - to a

positive economic growth in Q3 and possibly part of Q4 to

be followed by a relapse into a second recession by year

end or early 2009 when the effects of such fiscal stimulus

fade out. Such a W-shaped recession – effective a

U-shaped recession with a small temporary upward blip in

the middle of it (thus a W-shaped one) cannot be ruled

out. The main question mark is whether the tax rebate that

US household will receive in the middle of 2008 will be

mostly consumed – thus leading to a positive Q3 growth –

or will be saved in which case we will have a U-shaped

recession rather than a W-shaped one.

One can make arguments either way on the effect on

consumption and savings of a temporary tax rebate.

Given how stretched are the financed of many US

households it is likely that a good part of this tax rebate

will not be spent: it may be rather be used to run down

very high credit card balances (or other unsecured

consumer credit) or be used by distressed households to

postpone delinquencies on their mortgages. If a good part

of the tax rebate were to be saved than consumed we

would have a U-shaped recession. Otherwise it is likely

that we would observe a W-shaped recession. Either way

the recession would be longer and deeper - rather

than shorter and shallow – as a positive surge in Q3 in

private consumption would quickly fade out once the

effects of such a fiscal stimulus fade away by Q4 or year

end.

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

more aggressively. Thus the risk of a decade-long

economic stagnation is quite limited so far.

Still with a severe recession lasting 12 to 18 months, a

severe financial crisis and credit crunch this will not be a

run-of-the-mill recession. This will turn out to be the most

severe recession and financial crisis that the US has

experienced for decades. Thus, the current conditions

and valuations in US equity and financial markets – that

currently price a mild and shallow recession – will be

proven wrong as the bottom of the real economic

contraction and the bottom of the financial and credit

losses are ahead of us rather than behind us.

The sense of complacency in financial markets –

especially equity markets – following the Bear Stearns

rescue will be dashed in the next few months as an

onslaught of poor macro and financial news will lead to

further realization that aggressive monetary policy easing

by the Fed will not prevent a severe recession and the

ensuing financial losses.

Indeed, in spite of the partial recovery of equity markets,

conditions in money markets - as measured by interbank

spreads relative to policy rates or safe Treasuries-

remain very stressed both in the US and in Europe; and

the shutdown of most credit markets, the very high credit

spreads, the reduction of leverage and credit contraction

remain almost as severe as they have been in the last

few months. Thus, money markets and credit markets

remain very stressed and highly dislocated in spite of the

most aggressive orthodox and unorthodox policy

measures that have been used to try to unclog such

financial markets.

轉貼自︰

http://www.rgemonitor.com/blog/roubini/252460/

(Nouriel Roubini's Global EconoMonitor)

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