Tuesday, December 2, 2008

Trying to Understand the Recession

It is official now…the United States has been in recession since December 2007! Right now the current recession is the third longest recession since World War II and most economists believe that this recession will at least tie the other two recessions in terms of duration…a period of 16 months.

Among the major factors behind such a belief is that housing prices are still declining, housing sales are still falling, layoffs have just started to takeoff and financial institutions are still reluctant to lend…even if people and companies are willing to borrow. Some feel that the real recession is just starting to hit.

Growth-wise, real GDP rose, year-over-year, at a 0.7% rate in the third quarter of 2008, down from 2.8% in the third quarter of 2007 and 2.3% in the fourth quarter of that year. Real GDP declined in the third quarter of 2008 from the second quarter of 2008 and is expected to decline once again going from the third quarter to the fourth quarter.

The extent of this recession has even got some people talking about deflation!

Now that is something! It is something because the year-over-year rate of change in the Implicit Price Deflator of GPD, although it drops when there is a recession, has only become negative once since World War II and that was in the 1948-49 recession. (See chart from the Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=GNPDEF&s[1][transformation]=pc1.) Over the past seven quarters the Implicit GDP Price Deflator has averaged a 2.5% year-over-year rate of increase and increased by 2.6% in the third quarter of 2008 over the third quarter of 2007.

It is important to talk about what is happening to prices at the same time one is talking about what is happening to economic activity because that gives us a clue as to what factors are dominating economic activity. If both prices and output move in the same direction then one can say that demand factors are dominating the market. If prices and output move in opposite directions then one can say that supply factors are dominating the market. To understand what is happening in the economy, one must get some feel for which side of a market is dominating.
As the rate of growth of the economy has dropped from the rate of expansion that took place in the four quarters ending in the third quarter of 2007 (2.8%) to the four quarters ending in the third quarter of 2008 (0.7%), the rate of inflation for the same periods remained roughly constant or has declined modestly. To get such a result the drop in the demand for goods and services would have had to been roughly matched by the decline in the supply of goods and services over this time period. That is, neither side of the market strongly dominated the behavior of the economy over the past year or so.

As I have written in several posts over the past year, supply factors seem to be just as important as, or even more important than, demand factors in the current slowdown. That is, an adjustment is taking place on the supply side of the economy that must be reckoned with if we are to fully understand what is going on in the economy and respond to the situation as effectively as possible.

A possible reason for the shift in supply is that transitions are taking place in the economy or need to take place in the economy and this is impacting cost structures and organizational patterns in a way that is altering how people do business. For example, the increase in the cost of oil during the 2007-2008 period may have caused the transportation and energy industries to begin adjusting to a new world of alternative products and services that rely less on fossil-based resources. The subsequent reduction in the cost of a barrel of oil may have little impact on decisions because of the ‘price shock’ that people absorbed through the summer of 2008. The problems in the automotive industry are just one consequence of this. And, we are seeing a lot more adjustments coming in different segments of the transportation area that are not getting such a high profile. Also, new efforts to build ‘green’ industries may result from this.

Another transition is occurring in the financial industry where thousands of people are being laid off due to the downsizing that has resulted from the collapse of the financial markets. Financial institutions, I believe, are going to go through a substantial restructuring that will be based on information technology. In the past thirty years, the financial industry has shown how it can use the computer to design financial products. Now, along with the call to restructure the regulation of financial institutions, the financial industry is going to have to use the emerging information technology to control risk and enhance the openness and transparency of the industry. In moving in this direction the financial industry will become a real leader in the creation of information markets on which the rest of the economy will model itself.

Information technology continues to transform itself and in so doing will continue to create opportunities for other industries to transform themselves. The spread of information is going to accelerate with search being an integral part of this expansion along with greater and greater connectivity between users throughout the world. Computer networks will more and more become decentralized rather than centralized.

Another area where substantial transitions are taking place is in the area of State and Local governments. The model that has been used in this arena developed after World War II and is in need of a vast overhaul. In all likelihood, the current financial difficulties are going to result in these governments modernizing their function and structure while at the same time they help rebuild the infrastructure.

These are just a few of the major transitions that are taking place in the economy right now and that predominantly affect the supply side of the economy rather than the demand side. In all the efforts to “get the economy going again” we must not restrict or prevent these changes. That is, the government programs that are designed to stimulate the economy must not “lock us into” the old way of doing things. A bailout of the auto industry that keeps things “as they are” will not be helpful in the longer run.

It could be that the economy of the United States, and the world, is now going through a major restructuring, a restructuring that seems to occur every 60-80 years or so. In a sense, we are going from one age into another. One could say that the United States went through another major restructuring in the 1930s when the country was transitioning from an economy based predominantly upon agriculture to one that was based predominantly upon manufacturing. Maybe this is the time of transition from manufacturing to (you insert your term for it). Maybe the world of the ‘manufacturer’, and all that supports it, has significantly passed its peak and government props can no longer sustain it.

Two things can be drawn from this. First, government programs that just rely on stimulating demand will not prove to be very effective. The transitions must take place. They will take place relatively rapidly or they will take place at a much slower pace if the government supports the status quo. We…the government…must be careful here.

Let me state this again…the adjustments are going to take place…whether or not the government slows them down!

Second, these areas of transition are going to create major new opportunities for investment to those that are lucky enough…or wise enough…to choose the right companies. Referring to the 1930s once again, one can reference many investments that provided exceptional returns to those that sought them out and committed to them during the period in which the economy was adjusting to the brave new world that was coming. It is my belief that there will be numerous such opportunities available to us in the near future.

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