Hamish McRae: The GDP figures were profoundly gloomy ... but they were wrong

Economic View

Sunday 26 July 2009 00:00

We are not through this one yet by any means. On Friday, the numbers for second-quarter GDP showed that the economy was not only still shrinking, but shrinking by more than independent economists had predicted. GDP was down 0.8 per cent on the quarter, which is really bad.

If the figures are right, we are on course now to a recession on a par with that of the early 1980s or the early 1930s. Indeed, this is even worse than the 1930s, as you can see from the main graph. Yet share markets, here and elsewhere, have staged a strong recovery in recent days, with the FTSE 100 index nudging towards 4600; the last time it broke that barrier was at the beginning of January. If the economic news is gloomy, why are markets cheerful?

Let's come back to markets in a moment, and focus first on the economy. There is a real puzzle here. Those figures feel wrong. I would be the first to acknowledge that I may be making a mistake here but I do expect these estimates to be revised upwards as more data comes in. Why?

Four main reasons. The first is that the initial estimates of GDP are based on output data and, while you can get a good feeling for the output of manufacturing, it is much harder to get an accurate assessment of output from the service industries, and services are much more important than manufacturing in their share of the economy. Private-sector services are reported as being down. Well, maybe they were but it does not feel like that to judge from other data.

The second reason is that retail sales have been pretty strong, the June figures particularly so, and that is an important component of the economy.

The third is that monetary data from the Bank of England suggests that broad money supply is rising and that the Monetary Policy Committee seems a little more optimistic that its effort to pump up the economy is working. That would square with slightly better housing market conditions.

And the final and to me most telling reason is that the monthly estimates of GDP from the National Institute suggest that the economy reached a turning point in the second quarter, definitely rising in June. They are only estimates and the National Institute is very sombre about the likely pace of recovery. But it has a good record of getting GDP right and I would trust it as least as much as I would the official statistics.

I am not claiming that the economy actually grew in the second quarter, though I would not completely rule out that possibility. I just think it is probable, when all the numbers are clear in a couple of years' time (yes, it takes that long for the full picture to emerge) that things did not fall nearly as fast as suggested. Further, I think we will see this third quarter as the bottom. What does that then suggest about the cycle?

Have a look at the main graph, which compares this cycle with previous ones. Two points stand out. One is that whether I am right or not, we have headed down very fast. This is a bad recession, whatever gloss you try to put on it. The other is that even if things have bottomed out, it will be several years before output climbs back to the peak of early last year. There is a reason for this. It is that all recessions, this one or previous ones, take time to correct themselves. I say "correct themselves" because government policies, be they good, bad or indifferent, cannot suddenly correct the imbalances that led to the recession in the first place. They cannot correct the housing bubble; or the bank losses; or (except to a limited extent) the shrinking of the availability of credit. And they certainly cannot correct the collapse of world trade.

So even if this were a shallow recession, on the lines, say, of the early 1990s, it would take three years to get back to the peak. In the early 1980s it took four years. So it seems pretty safe to predict that activity will not return to the level of early 2008 until at best early 2011, and at worst early 2012.

It also seems pretty safe to predict that even if there is a bounce in the autumn, there will be at least a year of lack-lustre growth. So why are markets cheerful?

The short answer is that they are not. They are merely somewhat less gloomy. The graph on the right puts the present recovery into context. Yes, there has been a decent recovery since March but there is a very long way to go. However, what does seem to be happening is that having tried several times to break through the 4500 point, last week it definitely managed to do so. You would now expect it to move into a new trading range, perhaps between 4500 and 5000, for the second half of this year. That, at least, is the view of Mike Lenhoff, a strategist at Brewin Dolphin, who has set 5000 as a year-end target for the FTSE 100 index. But that does very much depend on company profits recovering. That ought to happen, given the positive responses companies give in the various purchasing managers' surveys around the world – there was goodish data from both Germany and the eurozone as a whole on Friday.

What we will have to get used to for the next couple of years will be a lot of conflicting information. There will be much "green shoot spotting", people trying to talk up the economy. There will by contrast be plenty of gloom-mongering too. The only sensible response to this is to be sceptical of both.

The most unusual feature of the downturn is the huge burden of debt that has been accumulated by individuals, by some companies and now increasingly by governments. The issue is the extent to which this debt burden holds back the recovery. It cannot just be wished away. It has to be serviced and eventually paid down. For the next year or two, the main burden of that will fall on individuals, but when we get ourselves into better shape, it will then be the turn of the Government to get its borrowing under control. That will take the best part of a decade – and it is not just the British Government that will have to pay down its debt. Other governments will be in much the same situation, though in most instances the adjustment will not be quite so harsh.

And markets? They look forward. They have in the past pretty consistently signalled turning points in the economy some six months in advance. Last autumn they went into panic mode, and you might say they correctly predicted just how dreadful 2009 was going to be. But they turned upwards in March so the reasonable assumption would be that the recovery begins in either the third, or maybe the fourth, quarter of this year. Besides, in a world of near zero interest rates, companies that pay reasonably reliable dividends look a not-too-bad place to put some money.

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