Saturday, February 27, 2010

Economics 27/02/2010: Double dipping

As of recent days, the media has become finally aware of the serious risk of double dip recession - here in Ireland (qualified below) and in the rest of the world. The reason for this awareness is most likely the ongoing crisis in the Euro area debt markets. But the real cause for concern should be the overall markets dynamics.

First, let me qualify what I mean by the double dip recession in Ireland. Officially, to have a double dip you must exist the first recession - which can only happen if Irish economy were to post at least a quarter of positive growth. There is an inherent asymmetry in the way we term the business cycle. While going into a recession requires two consecutive quarters of negative growth, recovery set in after just one quarter of positive growth. The second dip for a recession, however, requires again consecutive two quarters of negative growth.

Which, of course, means that were recoveries distributed following the same probability distribution as recessions, the risk of a double dip recession will be lower than the risk of a single quarter negative adjustment post-recovery. And lower still than a recovery. Statistics bear this out, with double dip recessions being relatively rare.

Of course, for Ireland, a double dip recession in current environment will simply mean that instead of turning first positive, then negative again, our GDP (or as I would prefer to measure it - GNP) growth turns more negative than it currently stands.

Definitions aside, what we do currently know points to a strong probability of a double dip recession in the US. Here is why.

As I pointed out in a recent article in the Sunday Times (here) I argued that residential investment is the leading indicator for both recessions and expansions. What we are now seeing the US and the UK are the first signs of renewed problems in this sector, as stimulus and tax breaks wear out.
  • Resales of U.S. homes and condos fell 7.2% in January to the lowest seasonally adjusted levels in seven months. This marks two consecutive months of falls that ended an H2 2009 rise. Sales of existing homes have fallen two consecutive months after rising steadily through the fall on the back of a federal subsidy for first-time home buyers. Inventories of unsold homes fell 0.5% to 3.265 million, or 7.8 months of supply at the current sales pace. And this does not bode well with Irish data, where declines in inventories (see Daft.ie latest reports) were seen as an 'improvement' on the overall trends.
  • Sales of new homes in the U.S. fell in January to the lowest level on record. Sales were projected to climb to a 354,000 from an originally reported 342,000 rate in December, according to the median estimate in a Bloomberg survey of 72 economists. The supply of homes at the current sales rate increased to 9.1 months, the highest since May 2009. Purchases of new homes reached an all-time high of 1.39 million in July 2005. January 2010 sales dropped 11.2 percent to a seasonally adjusted annual sales pace of 309,000 units, the lowest level on records going back nearly a half century.
  • Foreclosures are continuing to rise and with them - banks failures (see a good post on US banks weaknesses here).
So overall, the US lead indicators are pointing to a double dip.

Ditto for the UK, where home prices are now hitting the reversals of recent gains. Average house prices in the UK fell 1% in February after nine consecutive monthly increases. Although average prices in February were 9.2% higher than in February 2009, according to the Nationwide Building Society, it is the dynamic, not the levels that matter.

And EU economies are now in the reversal as well:

  • Confidence among German corporates contracted unexpectedly in February, according to the sentiment index released by the Ifo Institute - winter weather is being blamed, but there is little evidence this is really what is happening on the ground with exports tracing consumer demand downward;
  • Italy's state-financed ISAE published a new survey showing that Italian consumer confidence is now in a free fall once again;
  • Exactly the same is happening in France, where consumer spending is falling as the state cash-for-clunkers program ended, causing decline in car sales;
  • Bank of France data shows that credit to the private sector have slowed down even further in January, while credit to companies was actually falling once again.
Since France and Germany led the Euro area out of recession last summer . That recovery was driven by government stimulus programs and a pickup in global trade. Domestic consumers, meanwhile, were left holding the bag - as usual - in the block which prides itself on selling premium stuff to foreigners and keep its own citizens as savings-generating serfs of the exports-driven economies. Net result? Q4 2009 Germany's GDP growth was flat in quarter-on-quarter terms.

This, of course, is bad news for Ireland. There are three major problems that lay ahead of our recovery and none are being helped by the weakening global economic climate.

First, there is a problem of fiscal deficits financing. Slowdown in the EU and US means that there will be no easing in the glut of new bonds issuances this year. Euro area alone is expected to raise its debt issues to roughly $2 trillion worth of bonds since the beginning of the crisis. A minnow, like Ireland, is bound to see its yields shooting straight up if we are to finance our deficits through open market placements. And there is no hope for placing these bonds elsewhere, as the ECB is hell-bound on clawing back on its quantitative easing programmes of 2009.

The ECB can do so in two ways - hike the rates, or reverse collateral inflows back into the banks. Alas, the former is out of question for now, with economic situation deteriorating. This leaves the latter as the only option. Irish banks - the most dependent on ECB lending throughout the crisis - will suffer heavily through such an exercise.

Second, EU growth reversal spells the end of our exports buoyancy and the hopes for foreign investment boost from the US MNCs aiming for EU presence expansion.

Third, absent growth in the Euro area, the markets will continue scrutinizing closely public finances of the member states. I will post on this issue later today/tomorrow, but the core message here is that Ireland is simply not in a very good position to escape severe downgrades from the markets, given the fact that our policies to-date have been heavy on squeezing all liquidity out of the households.
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