Benchmarking the recession: longer and deeper
Over at Worthwhile Canadian Initiative, Stephen has posted a nice graph comparing the average projections from the private sector (as compiled by the Parliamentary Budget Officer) and the Bank of Canada with the paths of the last two recessions. He is poking a hole in a story that there is a gap between the more optimistic Bank view and the private sector forecasters.
In fact, the Bank and private sector forecasters have been roughly on the same page for the past couple years. That is, totally delusional about the future prospects of the Canadian economy given some pretty obvious signs. It is likely that the Canadian recession will have begun officially in the fourth quarter of 2008 after flatlining for the previous three quarters. And yet a year ago neither the Bank nor the private sector forecasters saw a recession coming at all, and while there were some downgrades as the year progressed, the view that Canada would not experience a recession persisted right into the same fourth quarter. In other words, neither the Bank nor the private sector projected rain until the drops started to fall on our heads.
So why should we trust their opinions looking forward? We should not. The Bank’s forecasts have no credibility as they are in the position of trying to restore confidence and have already used up almost all of their conventional ammo (through interest rate cuts). They are thus biased towards a more optimistic forecast. The other private sector forecasters are just hopeless. Those who are calling for a return to our previous growth path in just over a year owe us a good explanation of what is going to drive that resurgence.
To me, Stephen’s graph lends support to the view, expressed by many on this blog, that we are in for a rougher ride that will probably last through 2010, with a period of stagnation or jobless growth following that for a couple years. Even if we just assume that we will follow the average trajectory of the past two recession the outlook is pretty grim, and this recession may even be worse. The economy has begun downward spiral with rising unemployment fueling lower demand, which will lead to more unemployment. All on top of a major shift in psychology â€“ an increase in liquidity preference as highly indebted households retrench on spending and businesses retrench on making new investments. The corporate sector has been in a net saving position in recent years, so the challenge is less about access to credit as it is the context of weakening demand.
The mainstream diagnosis is that this is all due to a credit crunch in the financial markets resulting from US sub-prime mortgages. But that is more the symptom, and the data point to continued increases in bank lending. The real underlying driver is the collapse of the housing bubble writ large, with sub-prime mortgages being the tip of a very large iceberg. Housing resale prices will continue to fall this year and maybe next year, with depressed activity undercutting the total volume of sales and more importantly housing starts. In BC (where the bubble was arguably most acute) it is estimated that housing starts will be 45% lower in 2009, a huge hit for an economy that has boomed with residential construction in recent years (equivalent to about 3.5 percentage points of GDP). Add in the popping of bubbles in stocks and commodity prices, and an overall context of weak US demand, and the picture is not pretty for the Canadian economy. The Obama stimulus package squanders one-third on tax cuts, and another chunk is funding for state governments to avert their cutting spending to balance their budgets so it is not really stimulus.
The outcome depends greatly on the response of governments, with much of the action so far on the monetary policy front, and only more recently fiscal policy. But the perceptions of what is causing the recession and its likely duration have meant a much weaker fiscal response than is necessary. It is notable that there is a big difference in the fiscal/monetary policy mix compared to the previous recessions in the graph, however, though I think the fiscal taps are just starting as provincial budgets get tabled, and another round of federal stimulus will come next year.
One major area of concern is around automatic stabilizers, as the federal budget did essentially nothing to shore up the EI system. The restructuring of EI goes back to Paul Martin and the 1995 budget, and the new system has not had to deal with a recession yet. Two week waits, high number of weeks worked to be eligible, 55% replacement rate (with a max of $435 per week), and no coverage of the self-employed all undermine the effectiveness of EI. Roughly the same can be said of provincial social assistance programs, as benefits are too low and many hurdles have been made to access them.