Commentary: international recession and recovery.

Weale, Martin

Introduction

In the UK already bad output figures for the first quarter were revised down in June to show a contraction of 2.4 per cent. While the national accounts indicate a larger fall (2.6 per cent) for the second quarter of 1958, methods of measurement were then different and it is probable that, were current statistical techniques used for the whole of the ONS quarterly data set which starts in 1955, the first quarter of this year would be the sharpest output fall recorded. It was probably the worst quarterly economic performance in the UK since the 1926 General Strike.

Nevertheless, indicators now suggest that the pace of economic decline is much slower than it was at the start of the year in most advanced countries. Despite the fact that our hope that March would prove to be the bottom of the economic cycle in the UK was contradicted by data for May, our view, in common with much other analysis, is that the period of sharp recession is giving way to stagnation. It would, of course, be a mistake to assume that, simply because the period of recession may be ending, there is bound to be an immediate resumption of normal economic growth.

[FIGURE 1 OMITTED]

Britain's experience of the recession has so far been worse than the average of advanced countries. Of the twenty-eight countries for which the OECD provides quarterly data, average output has fallen by 4 per cent between 2008Q1 and 2009Q1. As figure I shows, in the United Kingdom it has fallen by 5 per cent while in Germany it has fallen by 7 per cent and in Japan by over 8 per cent. We first examine the international nature of the recession and the factors which account for these differences.

The international nature of the recession

The recession has been global in its extent, and probably more so than other postwar recessions. Most of the focus has been on the effect of the recession on world output, as we discuss on page 8. We now expect world output to fall by 1.5 per cent this year. But an impression of the spread of the recession can be better gained by looking at the proportion of countries reporting rising or falling output as summarised by diffusion indices. In figure 1 we show the percentage of OECD countries reporting a rise in output, as shown by their quarterly GDP figures. The figures are weighted by the size of the economy, so that in any period when each indicator shows an increase for the United States, the indicator takes a value of 36 per cent even if output falls everywhere else. The graph also shows periods of recession defined as those when fewer than half of the economies, after weighting for size, are reporting growth for at least two quarters, or when single quarters with fewer than half of the economies reporting growth follow in quick succession. It is clear from the graph that the spread of the current recession is broader than that of the earlier recession in the mid-1970s and early 1980s. It also provides the only occasion in the dataset when more than half of the economies have reported contracting output for at least three quarters in a row.

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The quarterly data do not provide a detailed short-term picture. Monthly industrial production data tend to be more erratic than GDP data, both because monthly data are more volatile than quarterly data and also because industrial production is more volatile than the economy as a whole. But they have the advantage that they are available on a monthly basis. The diffusion index calculated from these monthly data, again weighted by economic importance, points clearly to an easing of the recession in the Spring of this year. The most important factor behind this shift has been the beginnings of a recovery in Japan which has a weight of 12 per cent in the index. This comes after an extremely sharp contraction in industrial production there.

While the recession has been worldwide, one can nevertheless investigate the factors which might explain, for example, why Germany's experience is worse than our own and we now examine this.

An explanation of international differences

We explored these differences by means of a regression equation. We found the following relationship with Y representing GDP, Trade Surplus representing net exports as a proportion of GDP in 2007 and Gov Cons the contribution of government consumption to growth in GDP over the period 2008Q1 to 2009Q1.

log [Y.sub.Q1,2009] - log [Y.sub.Q1,2008] = -0.14 TradeSurplus
 (0.06)
 + 3.05 Gov Cons-0.05
 (1.17) (0.01)

[R.sup.2] = 0.46

S.E. = 0.02

Standard errors shown in brackets

The regression used data for Australia, Austria, Belgium, Canada, Czech Republic, Denmark,, Finland, France, Germany Greece, Hungary, Italy, Japan, S. Korea, Netherlands, New Zealand, Poland, Portugal, Slovakia, Spain, Sweden, Switzerland, UK, USA.

[FIGURE 3 OMITTED]

We explored a range of other effects such as those arising from exchange rate and interest rate changes. These were not statistically significant; one explanation may be that, to the extent that these represent responses to the crisis, it becomes statistically difficult to separate their effects from their causes. The same point might be made about government consumption, but the OECD (Economic Outlook, June 2009, p.60) suggests that very little of the fiscal response to the crisis took effect in 2008, so the risk of contamination in this way is relatively limited.

We also investigated whether the composition of output played any major role. It is sometimes suggested that the worse experience of Germany and Japan may be due to the high share of manufacturing or capital goods production in their economies. But once the trade surplus was included there did not seem to be any role for industrial structure. We were also clear that it was the trade surplus rather than exports and imports separately which mattered; when these were entered separately they had almost exactly the same coefficient but with opposite signs.

The regression results are not intended to do more than summarise the correlations in the data over the period. They suggest that output fell by 0.14 percentage points for each percentage point of trade surplus as a proportion of GDP. This accounts for 1.4 percentage points of the 2 percentage point bigger fall in Germany than in the UK.

While a trade surplus accentuated recession, a positive contribution from government consumption was an important means of mitigating it. The coefficient of three on Gov Cons is large, even taking account of plausible multiplier processes; we note that the standard error shown under the coefficient implies, however, that we would not reject a coefficient much closer to one. But in the short term the impact effects of what actually happened over the period are summarised in the regression equation.

With a uniform collapse in world trade, countries whose imports exceed their exports find that the collapse of trade increases domestic demand, while the reverse is true for countries whose exports exceed their imports. There are many good reasons why such an analysis should be regarded as incomplete. Movements in net trade, like government consumption, lead to multiplier processes and the multiplier is sensitive to the extent of import penetration. Nevertheless the empirical importance of net trade in explaining what has happened during the recession points to a trade recession as having been a driver of the national experiences in its own right rather than simply a consequence of coincident domestic recessions induced by the global financial crisis which began in August 2007. Among the advanced countries, surplus countries have been more exposed to recession than deficit countries and this seems to be a characteristic of their generic exposure to trade rather than a consequence of what they produce. But this is against a background where, in an average country whose trade was balanced in 2007 and where government consumption made no contribution, output fell by 5 per cent between 2008Q1 and 2009Q1.

International trade and inventories

What might give international trade this role? One plausible explanation is that bank finance for international transactions became much more restricted than did bank finance for domestic transactions in the immediate aftermath of the collapse of Lehman Brothers. There may also have been a tendency to protection, but this would have been expected to lead to domestic output substituting for internationally traded goods and services.

Sharp recessions are frequently in large part the consequence of businesses wishing to reduce their stock levels. If, perhaps because credit is tight, businesses want to reduce their stock levels from, say, twelve weeks' output to ten weeks' output, the consequence is that, for two weeks demand can be met without any production and, over the year as a whole, output falls by about 4 per cent. An important feature of the past year has been that some supplies of internationally traded goods have been met from stock rather than from production and this has hit the export surplus countries disproportionately.

As we stress in both the world and UK chapters, the recent signs of an improvement are probably mainly a consequence of the process of stock reduction having slowed with positive consequences for world trade. Even if both stocks and some components of other final demand are still falling, more output is being met from production rather than stocks than was the case at the start of the year. But, once stock levels stabilise, they will not be in a position to offset any continuing declines to final demand and thus there is a risk that, after a period of stagnation or weak growth, there will be a second period of recession.

Longer-term pressures on demand

The prospects for final demand do not look good internationally. We have argued that the aftermath of the recession is likely to leave UK output 4-5 per cent lower than it would have been had pre-recession conditions been maintained. A part of this is the consequence of an assumed contraction in the importance of the financial sector, with people employed in that redeployed to other sectors of the economy where their value added is likely to be much lower than it was in the financial sector. But the majority comes from the assumption that the cost of capital rises, having been unusually low in the middle years of the decade. This will make production less capital intensive, leading to falls in both the desired capital-output ratio and in the overall level of output.

Most advanced countries will probably face permanent losses of output smaller than that in the UK. They are less vulnerable to a reduction in the measured size of the financial sector. But they are likely to face a similar process, with an increased cost of capital leading to investment falling sharply as the desired ratio of capital to output is reduced.

The capital-output ratio can be reduced either by a short period of extremely low investment or a longer period of rather low investment. Our forecasts inevitably make assumptions about the speed of the process although there is little past experience on which to base this assumption. If it is much more rapid than we have assumed, then the recession will be steeper than we have forecast, with a double dip but a faster eventual recovery, while if it is slower stabilisation may give way fairly soon to modest growth.

A permanent reduction in output also implies that household consumption will be permanently lower than it was before the crisis. Again, this adjustment can be made as a step down followed by a resumption of growth profile similar to that before the crisis or a longer period of stagnant consumption followed by a later resumption to growth. It is not very likely that historic rates of consumption growth would be resumed without consumption falling further than it has or stagnating for several quarters.

These downward pressures might make a double dip seem likely in any case. But for many advanced countries they are offset by the prospect of export growth. The recession has affected emerging economies as well as advanced countries. But it is much less likely that they will suffer a permanent reduction in output since it did not appear that the cost of capital in these had fallen during the boom period. Thus, once they are no longer affected by de-stocking, they are likely to show a fairly sharp recovery resulting in export-led growth for many advanced countries. The United Kingdom will be a particular beneficiary of this given the fall of the exchange rate late last year so that we forecast output will rise by 1 per cent next year after a fall of 4.3 per cent this year; if this export demand does not materialise, output will continue to fall. The United States, on the other hand, is likely not to gain any net benefit from this source, but is much more strongly supported by its fiscal initiatives than are other countries. Its contraction this year is expected to be 3.2 per cent but output will rise there next year by only 0.6 per cent. Our estimates of forecast ranges, presented in the forecast chapters, continue to be derived from past forecast errors, but a reasonable conclusion is that, for the reasons explained above, forecast uncertainty is at present unusually high.