Global: Double-Dip Alert

Stephen Roach (New York)



Washington statisticians have once again redefined the economic landscape. Courtesy of the so-called benchmark revision of the national income and product accounts, the recent performance of the US economy has been cast in a very different light. The direction of this annual revision was hardly a shocker. The incoming monthly flow data had tipped us off to expect a weaker picture than the previous data had painted (see my 27 June dispatch,"House of Mirrors"). But there is more to this revision than statistical noise. In my opinion, the new data now place the US economy right on the brink of another recessionary relapse -- the dreaded double dip.

The annual revisions typically cover a three-year period -- in this instance, 1999 to 2001. But the most interesting portion of this revision came in the five-quarter interval 2Q00 to 2Q01. Real GDP growth was revised down in each of those five quarters, and small increases in the first half of 2001 were restated as modest contractions. Consequently, the original script of a one-quarter recession was rewritten as a three-quarter downturn. It’s still one the mildest of America’s post-World War II recessions -- a peak-to-trough decline of just 0.6%; while that’s double the previously estimated contraction and now equal to that in the mild downturn of 1969-70, it is less that half the -2.0% cyclical norm. Even so, the duration of the recent downturn is now more in keeping with the 11-month contraction of the standard US business cycle.

The real story, in my view, is that the data revisions provide validation for a very different macro perspective than that of the typical business cycle. At work, in my view, has been a perfectly logical sequencing of post-bubble aftershocks in the US economy (see my 12 July dispatch,"A Different Lens"). The classic recession is caused by a late-cycle acceleration of inflation -- and the Fed’s intervention to stop it. Inflation was not a factor in this downturn. At work, instead, were the aftershocks of a popped asset bubble -- initially manifested in the form of a sharp downturn in business capital spending. The data now show that real business capital spending fell by $88 billion over the three-quarter recession period, 1Q01 to 3Q01-- fully 1.5 times the drop in real GDP over the same interval. In other words, the depth of the recent recession was contained by offsetting resilience elsewhere in the economy -- especially durables consumption and residential construction activity. Ironically, those are the two sectors that normally account for the bulk of the contraction in a typical downturn. In my view, there can be no mistaking the unique character of this post-bubble recession.

The data revisions also provide validation for the admittedly simplistic"recession-warning model" that I have long embraced. It has two key ingredients -- the first being an economy that slows to its"stall speed." In the case of the US economy, I define the stall speed as positive growth in the 1% to 2% zone -- a sluggish growth pace that leaves the economy lacking a cushion to shield it from those all-too-frequent shocks. The second ingredient is the shock itself -- that unexpected bolt from the blue that tips a stalling economy into outright recession. The unwinding of the IT bubble was just such a shock -- it accounted for 70% of the drop in overall business capital spending during the first three quarters of 2001 and more than 100% of the cumulative drop in overall GDP. In retrospect, that was a lethal combination -- a stalling US economy plus a classic shock. Therein lies the key to the internal dynamics of the recession of 2001.

That same simple recession model may well hold the key to the US double dip that I believe is coming. Not only was the nature of the benchmark revision a surprise, but so, too, was the anemic 1.1% growth estimated for 2Q02 -- less than half the downwardly revised consensus expectations; moreover, as recently as a month ago, most were looking for second quarter growth in the 3.5% range. However, courtesy of shortfalls in consumption and business capital spending, in conjunction with a high import content to the inventory correction, real GDP growth fell back to the lower end of the stall-speed zone. This is a highly unusual development for a US economy that is supposedly in recovery. Typically, in the third quarter of a cyclical upturn, real GDP growth has averaged 5.6% (based on the last six cyclical recoveries stretching back to the late 1950s). Growth in the period just ended was one-fifth the cyclical norm and half the previously weakest outcome at a comparable period in the cycle (a 2.2% increase in 4Q91). With the US economy now back at its stall speed, all it would take would be another shock to trigger the double dip. Several such possibilities concern me -- intensified corporate cost cutting that triggers a new round of layoffs, a credit crunch, a downturn in housing markets, and another geopolitical shock. Just as it was the case in late 2000, it wouldn’t take much to push a stalling US economy over the brink and back into recession.

I continue to believe that there is a deeper meaning to all this. Like it or not, the post-bubble excesses of the US economy remain largely intact. That’s the unfortunate outcome of a still mild recession -- it doesn’t result in a major purging of long-standing imbalances. That’s especially true of America’s gaping current-account deficit. The current-account gap widened to 4.3% of GDP in 1Q02, and based on the import surge just reported for 2Q02 (+23.5% in real terms) undoubtedly expanded further in the period just ended. However, the benchmark revisions will make the current-account gap look far more onerous as a share of GDP. That’s largely because the level of nominal GDP was lowered by 1.2% in 2001; but it also reflects the likely impacts of downwardly revised exports (1.6% lower in 2001) and upwardly revised imports (+0.2% higher in 2001). The net result is that the current-account deficit as a share of GDP could easily be one percentage point larger than we had previously thought -- surpassing the 5% threshold that typically triggers a current-account adjustment. Needless to say, that has important implications for capital inflows into the US and for the dollar -- requiring more of the former and implying more downward pressure on the latter.

Nor have the other post-bubble excesses vanished into thin air. The personal saving rate was revised up -- it now stands at 4.0% in 2Q02, about one percentage point higher than we thought it would be. But it remains well below its pre-bubble reading of 6.6% in late 1994 and less than half its 8.6% pre-bubble long-term average from 1950-94. Similarly, capital spending fell to 10.8% of nominal GDP in 2Q02, down from its 13.0% peak in 3Q02; while this suggests that the pruning of excess capacity is well advanced, this ratio typically falls to 10% of GDP at the bottom of a secular downturn in capital spending. In other words, there’s probably more to go in eliminating the capacity overhang. Finally, there’s no mistaking the lingering excesses of debt. Based on the unrevised levels of nominal GDP, debt ratios in early 2002 stood at records for households (76% of GDP) and businesses (68%). With nominal GDP having been lowered by 1.2%, these debt ratios will now be revised upward. Like it or not, the legacy of America’s post-bubble excesses remains an enduring feature of the macro climate. A double dip would go a long way in accelerating the painful, but necessary, purging of those excesses.

While the past is not always prologue for what lies ahead, the lessons of history should not be forgotten. Double dips have been the rule, not the exception, in business cycles of the past. Five of the past six recessions over the past 45 years have, in fact, contained a double dip -- the rare single dip occurred in the early 1990s. Moreover, in two instances -- the mid-1970s and the early 1980s -- there were actually triple dips. Double dips happen because demand relapses invariably occur at just the time when businesses are lifting production in order to rebuild inventories. With the current production upswing well advanced -- industrial production has risen for six consecutive months -- a demand relapse would come at a most inopportune time. Yet with the US economy now back to its stall speed, that’s precisely the risk. Courtesy of the government’s newly revised depiction of the US economy, the odds of a double dip have risen, in my view. I would now place a 60% to 65% chance on such a possibility in the second half of this year.

When all is said and done, I must confess to being amazed at the venom my double dip call still elicits. They tell me it’s now been discounted by battered equity markets -- the ultimate insult for a supposedly out-of-consensus call. As one of my favorite critics wrote me earlier today,"When you first started talking about it (the double dip), you were scorned and clearly a heretical fool. Now, you've been identified publicly as the guy who got it right. It’s priced in." Maybe -- maybe not. With the S&P 500 now up 14% in the past six trading days, the equity market is clearly less enamored of the negative macro scenario than was the case last week. I still believe an outright double dip would have actionable implications for stocks, bonds, and currencies.


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