Sean O'Grady: We'll bounce back for sure, but what goes up must come down
This is a recession like no other we have seen in 75 years because the banks are broken
Tuesday 26 May 2009
Why is the economy still shrinking? Apart from the more abstruse explanations we read about – global imbalances, the credit crunch and a massive debt overhang – the most immediate reason is that we are simply running our stocks down. At least half the fall in our national output seen in the past six months has been a reflection of "destocking" – the reduction in the levels of stocks that are held by manufacturers and retailers alike.
From peak to trough (so far), output has dropped by 4 per cent; about 2 per cent of that, maybe a little more, is down to lower stock levels. This is the "Honda effect", and is clearly visible in last week's detailed GDP statistics. Go to Honda's factory in Swindon if you want to see what it means. Things are very quiet there: a four-month production shutdown has been imposed as dealers sell the excellent Civic and CRX models made in Wiltshire out of stocks built up over previous months.
Honda has no cause to make any more for the time being. Overall – and before the scrappage scheme works its temporary magic – demand for cars is down about 25 per cent on last year. But production at UK car factories for the British market is down about 50 per cent. In Honda's case it has fallen by 100 per cent.
So that's the Honda effect, or what economists term an "inventory recession": a relatively small fall in demand for a product can be amplified dramatically as you move back down the supply chain. Parts makers and raw materials suppliers may see even more substantial volatility in their production and prices: it's one reason why the price crude oil fell from almost $150 a barrel last year to $60 or so now.
This happens in every recession and, in a way, it is nothing to panic about. There's no mystery to it: that, more or less, is what has been happening to the British economy and elsewhere. Indeed, in those economies more exposed to the inventory effect – the major manufacturing powers such as Germany and Japan – falls in gross domestic product are even steeper. Our tiny manufacturing sector (at 15 per cent of the national economy it is about as small as it can get) is one reason why our GDP fell by "only" 1.9 per cent in the first quarter of the year, but the Germans and Japanese saw drops of about double that magnitude.
Now, can you guess what will happen to the growth numbers for this quarter? What will happen will be the Honda effect – but in reverse. Let's say, for the sake of being able to "do the math" that Honda made one car in the first quarter of this year, duly recorded by the Office for National Statistics for its GDP data.
Now, say they make just 10 cars over the period from April to June – a purely hypothetical case (they ought to do much better than that). That is negligible in absolute terms, but it will seem like an enormous rise in percentage terms on the previous quarter – 1,000 per cent – and will contribute to a bounce in GDP that may surprise. Cue headlines about "green shoots", "turning the corner" and all the rest. There will be some truth in the breathless tales of an economy on the mend – but only some. Just as the first, depressing, inventory effect exaggerated the scale of the downturn, here and abroad, so will the recovery in output when stocks stop being run down – they will get to zero sooner or later – will overstate the health of the economy on the way back up.
Unfortunately, the bad news is that the bounce will not last and the economy may slide back again, for last week's GDP data also showed some more worrying trends. While something like 70 per cent of the fall in output we saw in the last quarter of 2008 was down to the Honda effect, only a third of the (larger) fall in GDP between January and March this year can be attributed to destocking.
So, the worrying thing is that the other two-thirds of the fall is down to more fundamental factors – especially a fall in household spending, on items such as cars, holidays and household goods. Consumer sentiment, a fragile flower at the best of times, is a necessary precondition for recovery but will be badly affected by rising unemployment, thus transforming the jobless numbers, a traditionally lagging indicator, into a leading one – a sort of economic negative feedback loop if you like.
The second depressing trend is the fall in investment, for two reasons. First, it is itself a sign that improving business sentiment is not yet being turned into hard cash spending on new equipment and plant (by the way, just as first-time buyer enquiries at estate agents aren't much converting into actual sales). Survey evidence is telling us that a recovery in business will come by this autumn – but not how vigorous that will be. Second, lower investment means that the longer-term growth rate of the economy will be depressed by a lack of new, more productive machinery to raise output per head and promote innovations in production processes and new products. That is the long-term price we will pay for this slump.
Beyond the GDP figures, we must never forget that this is a recession like no other we have seen in 75 years, because this time the banks are broken. The credit crunch hasn't gone away, it has just fallen away from the headlines as its consequences – boarded-up shops and factories, bust banks, joblessness, child poverty, homelessness, public finances out of control – have grabbed our attention instead. As the Deputy Governor of the Bank of England, Charlie Bean said last week: "We are still some way from having banks that feel sufficiently secure that they can lend normally, and investors that have enough confidence in the banks to provide them with sufficient funds."
The state, via the Bank, is taking up some of that slack, but the Bank itself admits the commercial banks can take much of the £125bn being pumped into the system through quantitative easing and simply sit on it – an uncomfortable position for all of us. The signs are, then, that the recovery will come, maybe soon, but that it will be an up and down phenomenon – a "W" shaped recovery for those who like things expressed in this fashion.
In the short term, the recovery may well be as dramatic as the downturn has been as stocks are rebuilt and output bounces back, also helped by exports – but the economy will then falter, as that effect wears off. Then, continued weak consumer spending, business investment and indeed public spending start to dampen that bounce.
By this time next year we will be well into the second U in our W; the credit crunch will still be hanging around like a bad smell, consumer sentiment will still be fragile, and we will be only a small distance into paying down our vast private and public debts. Put another way, our W-shaped recession/recovery will be a wonky, wibbly-wobbly affair.
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