The global recession is over

A host of Asian economies, including China, India and Japan, recorded growth again in the second quarter of the year and all of the major Western economies appear to have emerged from the downturn in the third quarter, implying the world economy began recovery in the early summer.

The shape of that recovery is now the focus for financial markets and policy makers, although most forecasters have revised projections for economic activity next year upwards, amid improved sentiment and strong gains in equity and most commodity markets.

Recessions are a periodic feature of economic life, but this downturn has exhibited a number of unusual features, which will also colour the upturn. This recession has been unusually long, for example, and a number of economies, including Ireland, have yet to recover. Historical comparisons can be most readily found in the US where the National Bureau of Economic Research (NBER) dates US business cycles to the month. There have been ten previous US recessions in the post-war era, with an average duration of ten months, and although the NBER has yet to announce the end of the current recession, it has stated that it commenced in January 2008, which gives a duration of at least eighteen months, if one assumes that the US emerged from recession in July. This marks it as the longest in US post-war history, and the longest since the Great Depression, which ended in March 1933 according to the NBER, having lasted three and a half years.

The scale of this latest recession is also unusual in that the global economy actually contracted in 2009, by an estimated one per-cent, whereas previous downturns have seen positive, if limited, world growth. The fourth quarter of 2008 was a watershed, as prior to that the downturn was shaping up to be moderate and, as such, in line with more recent experience. The collapse of the US investment bank, Lehman Brothers, in mid-September provoked an extraordinary chain of events however, with a freeze in international credit markets precipitating an unprecedented collapse in world trade, thereby engulfing most of the world’s economies. Industrial production in Japan, for example, had fallen by over 30 per-cent by early 2009, with German manufacturing experiencing a fall in excess of 20 per-cent.
This collapse in world trade also led to a third unusual feature, the synchronised nature of this global recession – few countries avoided a GDP contraction and by the second quarter of 2009 only one European economy, Poland, had positive annual growth, with the scale of decline ranging from -2.8 per-cent (France) through -7.4 per-cent (Ireland) to -17 per-cent (Latvia) and -20 per-cent (Lithuania).

The conventional policy response to a recession is monetary and fiscal easing, and this duly occurred in the major economies, although some central banks moved more quickly than others. Again, though, there was an unusual feature this time round in that the impaired nature of the Western banking system meant that the normal transmission mechanism for monetary policy was either broken, or at best severely damaged. What was once a quaint theoretical possibility – that interest rates could be cut to zero or near zero without having any discernable effect on activity – became an unnerving reality for central bankers. The response was a plethora of more unorthodox monetary remedies, including state guarantees for bank deposits, government injections of bank capital, the nationalisation or part-nationalisation of banks and the purchase of government and corporate bonds, the latter funded by printing money – or its modern equivalent – the creation of bank reserves.

It is too early yet to judge the success of such policies, and some of the fiscal measures have yet to take full effect. What is known is that in the wake of past recessions across the globe the recovery of lost output has been swift (on average, GDP has returned to the previous peak within nine months) but synchronised recessions tend to face a more protracted recovery period, particularly when accompanied by a financial crisis. Consequently, the major central banks may well be reluctant to raise rates too early, for fear of stifling the upturn, particularly as the output lost during the recession is so large relative to historical experience. The financial markets feel that rates can only go one way from here, nonetheless, and that is up, and the futures market is priced for the onset of monetary tightening in the US, the euro area and the UK by mid-2010. This may prove somewhat premature given the scale of the downturn and the question marks over the ability of the international banking system to supply sufficient credit.

The global recession may be over but one cannot say the same about Ireland’s recession – at least on the evidence of the figures published to date. It is true that GDP stopped contracting in the second quarter of the year but the scale of the fall over the previous nine months still left output 7.4 per-cent down on an annual basis. The Irish recession has differed from the norm in Europe in that the latter was primarily driven by a fall in exports whereas the catalyst in Ireland was a plunge in domestic spending, initially construction, then business spending on machinery and equipment and finally consumer spending. The Irish economy has seen a substantial re-balancing as a result – house-building now accounts for only 3.5 per-cent of real GDP against a peak of 11.5 per-cent in 2005, with exports amounting to 88 per-cent of GDP from 79 per-cent four years ago.

Yet conventional wisdom has it that the Irish economy requires a significant fall in wages to restore competitiveness, even though the external sector has held up remarkably well relative to domestic spending and our peers in the euro area – albeit heavily influenced by a narrow range of multinational exports. In fact, Irish unit wage costs in manufacturing have fallen some 10 per-cent against our main trading partners over the past 10 years according to the Central Bank, although relative Irish wages have risen by almost 40 per-cent over the same period.
The difference reflects much higher productivity growth in Irish manufacturing, and indeed the Irish data lends empirical support to the Belassa-Samuelson effect – an economic theory seeking to explain why prices are higher in richer countries. The idea is that high wage growth is warranted in high productivity growth areas in an economy, such as the multinational manufacturing sector in Ireland, but that this pushes up wages in other lower productivity sectors such as services. The result is price inflation in those sectors and higher inflation in the economy as a whole, even though the traded goods sector may remain competitive thanks to its superior productivity growth.

In fact, the Irish price level is now falling relative to the Euro area thanks to larger falls in food, clothing and footwear and rents in Ireland than elsewhere. This, alongside the historically low levels of interest rates, may offer some support for consumers but an Irish recovery will probably be driven by exports and business spending. As such, the path of the global economy will probably determine the timing of Ireland’s exit from recession.