The Current State of the Economy Lars Osberg Economics Department Dalhousie University Dalhousie Seminar 18/11/08

Slowing Economy + Financial Crisis = Recession “Labour market shortages” – recent worry?  long run labour market trends are always trumped by immediate realities September – November 2008  Unprecedented volatility + previously unimaginable policy response “most dangerous shock in mature financial markets since the 1930s” IMF – World Economic Outlook October 2008  Superimposed on pre-existing down trend Context + shock implies likely future trend

January 2008 view: “Optimism decline accelerates” “U.S. economy has slowed noticeably”  IMF World Economic Outlook, April 2007World Economic Outlook  a “midcycle pause” ?  early stages of a more protracted downturn Real economy forecasts revised downward every quarter since at accelerating rate Financial crises have short term impacts if:  Localized  Superimposed on robust real economy

January 2008 – not yet clear: Passing Breeze or Gathering Storm? “housing starts and the change in housing starts together form the best forward-looking indicator of the cycle”  Leamer (NBER Working Paper No )  Housing construction booms borrow output from future periods – current overhang of 750,000 units!! Residential construction – large % US job growth to 2005  Housing prices declining since % in 07/08?  Asset Price bubbles take long time to unwind (Japan) Housing wealth underpinned US consumer spending boom  Sub-Prime Mortgage debacle the official line: “Contained in implications for financial markets”

By January 2008 – little did we know! – general expectation was: US fiscal & monetary policy set to MAX  + 1% fiscal stimulus by March?  % in interest rates + promise of more  Canadian policy-makers more complacent Issue which was then unclear:  $600 in tax credits vs 1.3M foreclosures?  “pushing on a string” – where are the willing lenders & lower interest rates?

“After years of strong economic performance underpinned by sound monetary and fiscal policies, Canada’s growth is expected to slow this year as the downdraft from the U.S. Economy outweighs solid domestic demand supported by strong commodity prices.”  IMF Regional Economic Outlook April 2008 Expectations of the pre-crisis era -April 2008

Real output declining in USA well before crisis

IMF – World Economic Outlook October 2008 “The world economy is now entering a major downturn in the face of the most dangerous shock in mature financial markets since the 1930s. Against an exceptionally uncertain background, global growth projections for 2009 have been marked down to 3 percent, the slowest pace since 2002, and the outlook is subject to considerable downside risks. The major advanced economies are already in or close to recession, and, although a recovery is projected to take hold progressively in 2009, the pickup is likely to be unusually gradual, held back by continued financial market deleveraging.”

“Rapidly Weakening Prospects Call for New Policy Stimulus” World Economic Outlook Update – International Monetary Fund - November 6, 2008  Global activity is slowing quickly  Weakening prospects are depressing commodities prices  The financial crisis remains virulent  Consumers and firms are reassessing income prospects  Macroeconomic policy easing has been limited  The economic outlook is exceptionally uncertain  A stronger macroeconomic policy response could limit the damage

“Out of sample prediction” & long run ? - but 2009 gloomy

Housing cycle far from over Not yet bottom in USA – risk to overshoot

Y= C+I+G+(X-M) C: Credit crisis & Consumption  Expectations + credit availability + wealth effect I: Commodity price driven investment boom goes with resource/energy prices G: automatic stabilizers now much weaker than in recessions of early 80s and 90s  + Deficit dogma – in remission ? (X-M) – already down + US income slump  Decline in exchange rate – a lagged & partial offset

Good News: “Whatever it takes” – the new Central Bank mantra Large “temporary” shocks have real impacts Not just a liquidity/confidence crisis  Chains of real insolvencies still need resolution  Disappearing Wealth depresses consumption  “Repricing Risk” + Deleveraging has real effects  Not possible for everyone to decrease debt/income ratio simultaneously – but r > g still AND – can one push on a string?  Even if bank reserves become available, willing borrowers + willing lenders needed at micro level

Bad News: “Deleveraging” + Social safety net cut in 1990s Cyclical risk in Canada partly downloaded to provinces & families during 1990s  Under 40% of unemployed now get EI  SA no longer cost-shared Provinces ill-equipped to absorb (Origins of Rowell-Sirois) Less ‘Automatic’ stabilization for cycle Expenditure cuts to match declining revenues will be counter-productive BUT  Residual deficit dogma + inability to finance?

Recessions do end – but when? A: Housing cycle: 2006 start + 4 year average => return to trend growth ~ 2010 “Short & shallow”: assumes financial contagion is now contained + oil/commodity prices stay down + global imbalances resolve cleanly + “natural” revert  IMF October optimism – downgraded 3 weeks later! B: Japan+ scenario: “Long & very messy” Monetary policy ineffectiveness if low inflation Fiscal stimulus absorbed by “deleveraging” – D/Y  “Let the Chinese eat their T Bills” – how long can the USA resist the temptations of inflation ?  What then for Canada?