Tuesday, April 13, 2010

The Recession Isn't Over Until It's Over

Yesterday, the members of the National Bureau of Economic Research’s Business Cycle Dating Committee refused to make a decision.

The questions: Is the Great Recession over or not?

The Answer: Too soon to call.

“The committee is very careful to guard against surprises,” the chairman of the committee Robert Hall stated. Since the designation of the end of a recession is important for historical reasons, the committee wants to make sure data revisions don’t result in the need to revise it’s claim that the recession is over.

To me, the crucial part of the comment here is the emphasis on “surprises.” We get into a liquidity crises because we are surprised. Something happens in the market, something that was not expected, like the financial difficulty of a firm that, say, had highly rated commercial paper which was now going to be down-graded. This down-grading then results in investors pulling back from the market because of a concern that the commercial paper of other highly rated firms will be down-graded. Buyers in the market take a vacation until confidence is re-gained in the information pertaining to these other highly rated firms.

A credit crises occurs when investors get concerned about the value of the assets on the books of a financial institution, something that had not been questioned before. This “surprise” is connected with the fact that the financial institution either did not recognize that the value of their assets had changed and so had not reported it to the market, or, the executives in the financial institution did not want to recognize that the value of their assets had changed and were attempting to keep this information to themselves hoping that this value would revert to earlier, healthier, levels.

“Surprises” generally occur when events, which had been heading in one direction, change direction. Like, when housing prices that had been rising decade after decade begin to fall. Or, when the Federal Reserve reverses monetary policy without notice after continually following a different path. Or, when the overly optimistic expectations given an industry, like the dot.com startups, are recognized as too optimistic.

“Surprises” hurt because people, investors, have to revise expectations and markets have to absorb the new information, dig for additional information relevant to current valuations, and then adjust as fully as possible to all of the new information.

That is why, at this stage of the economic drama, we hope that the problem areas where future surprises might arise have been identified and that people and institutions are working to resolve the difficulties in as orderly a fashion as possible. “Quiet is good!”

For example, we know that states and local governments are having problems with their finances. No apparent surprises here. People are working to resolve these situations, both locally and nationally. For example, we hear that Felix Rohatyn is back at Lazard Ltd., working on the problems related to state and local government finance. He has proposed “an IMF” to help American cities and states “stave off budget crises.” (http://online.wsj.com/article/SB20001424052702304506904575180363245274300.html#mod=todays_us_money_and_investing)
Greece is obtaining help. But, the problems of Spain, Italy, and Portugal are well known and efforts are underway to resolve the issues being faced by these countries.

The banking system does not seem to be out-of-the-woods yet, but banks have seemingly identified their problem areas and are working to resolve them. The FDIC continues to move in an orderly fashion to close those commercial banks that are insolvent. Again, quiet is good!
Here, the Federal Reserve seems to be playing an important role in helping the commercial banking industry to get back on its feet. Having injected a huge amount of reserves into the banking system and seeing these reserves hoarded by commercial banks to the tune of $1.1 trillion excess reserves, the Fed is being very careful not to “jerk” these reserves out of the banking system at too swift of a pace. The effort on the part of the Fed is not to “surprise” the banking system by removing the excess reserves too quickly in a fashion similar to the “surprise” 1937 Federal Reserve decision to raise reserve requirements to reduce the unused reserves in the banking system just sitting idly on the balance sheets of the banks.

And, other areas in the economy are seemingly being handled in a calm, orderly manner.

The Business Cycle Dating Committee does not want surprises. Well, I don’t want any surprises either! I want a dull, ordinary, business-as-usual environment for dealing with all we have to deal with.

My guess is that the recession is over. Markets, in general, seem to be reflecting this fact. Certainly there are areas of concern here and there and new data releases are not always positive. But, financial markets seem to be reflecting that the economy is improving, even if at a very slow pace.

My first inclination is to trust the markets. It doesn’t mean that markets are always correct, but one should look first to see what the markets are trying to tell us and then, only after sufficient study, should we claim that the markets might be wrong if we can justify this latter conclusion. Yes, I still believe in markets. But, like many other people, I am more cognizant of the existence of Black Swans in the world than I was at an earlier date. We can still be hit by “surprises” but, for now, things are moving in the right direction.

There are still longer run problems in the economy that need dealing with. I will not get into those now but interested people can go to two of my recent posts to pick up my thinking on this point: See http://seekingalpha.com/article/197948-economic-recovery-what-s-missing and http://seekingalpha.com/article/192713-the-trouble-with-recovery. The existence of these longer run issues do not negate the belief that the Great Recession seems to be over.

The real question of this blog post is, does it matter whether this committee makes a decision or not? Robert Gordon, a member of the committee, has stated that delaying the decision “raises unnecessary questions about the health of the economy—that the whole committee wouldn’t think the recovery is strong enough to be able to say that it’s a recovery.”

Personally, I don’t think the committee’s decision is that important! It certainly is not going to impact my business and investment decisions.

Note: the Federal Reserve Bank of St. Louis has apparently already declared the end of the Great Recession. Check out all their charts. The grey area on the charts depicting the start of the recession begins in December 2007. The grey area on the chart, signaling the end of the recession, stops before the beginning of the third quarter of 2009. So much for that!

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