Monday, October 20, 2008

The psychology recession

From the SAF Floral Trend Tracker newsletter:

It ís too early to show up on the official gauges, but we're surely in a recession now. The economy was actually holding up through most of the summer, but the news since August has been dreary, and one-sided.

The credit turmoil, the bank failures and restructuring, and the stock market volatility has been bad enough, and the bipartisan drumbeat of "This bailout bill has to be passed now!" has to concern the most financially secure, while increasing the anxiety of the rest of us. The desperation of the nation's political leaders warning us about being on the edge of financial collapse has exacerbated the problem.

Strong Engines. The economic engine of growth remains strong — productivity growth has been vibrant, and exports have been soaring. That allows businesses to absorb higher prices on their inputs without raising the price on their output and helps maintain profit levels. If productivity growth were limping along, or declining, then firms would find business expansion much more difficult.

Moreover, a broad measure of economic activity known as real (or inflation-adjusted) final sales jumped a very healthy 4.4% during the second quarter, up from just 0.9% during the first quarter. The fact that it was so much higher than real GDP's 2.8% increase means that households and businesses bought a lot out of business inventories during the quarter (GDP equals final sales plus the change in business inventories). A big drop in inventories, as we just experienced, foretells increased production activity as businesses respond to strong demand and rebuild inventory to desired levels.

Sticky Wheels. But now credit, the oil lubricating the engine, has turned to sludge. That's meant that lots of companies, large and small, are facing problems financing their regular operations, much less their business expansions. This troubling development will cause and prolong our downturn. Without the credit market problems, the housing market workout and the oil price shock were being handled without driving the economy into a recession. The recently passed financial bailout doesn't solve the problem, but it will help as it removes many of the toxic mortgage securities off corporate balance sheets.

We are getting a break in oil prices, and the price of gas has dropped by 20% or so since the summer. Sure, that's after a big run-up, and itís tough to know if the price decline will prove to be a brief respite or a long-lasting correction. But the lower prices are giving household and corporate budgets more breathing room.

The economy will recover when confidence replaces fear in the credit markets, as it will (it always has). We'll still be reassessing value in many housing markets, and the recovery may be subdued as consumers avoid over-leveraging themselves with the purchase of big-ticket items. But then sticking to a low-debt diet will be a good thing, as we've learned.
Author Robert Barr is an economist in Northern Virginia

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