What’s more, recoveries that follow an SFC are protracted, taking seven quarters for the level of real GDP to return to the prior peak. At best, the United States is in the fifth quarter of the recovery cycle, and GDP is 1.3 per cent below the peak level. To match the mean historical experience, the economy would need to plod along at an average 2-per-cent annualized pace over the next three quarters, or 1.5 per cent over the next four quarters, to hit the historical marker. Either outcome seems quite plausible.
While GDP will likely reach its prior peak in 2011, the U.S. will still need to make up for the growth that would have normally occurred since 2008. That could take several years. Research suggests the economy could face structural changes for four or five more years. It is a sad testament of the times that this outlook for meagre growth and low inflation can be considered optimistic.
Given that the United States is tracking the traditional post-SFC experience, why would one now assume the outlier of a double-dip or deflation? None of the countries in the IMF study experienced either event (in the case of Japan, its lost decade was the product of a domestic financial crisis, not a synchronized financial crisis).
Obviously, there is no guarantee that the U.S. will continue to match the historical trend, and the sample of SFC occurrences in the IMF study is small. Given the fragility of economy, it wouldn’t take much to knock economic output into one or more quarters of decline. I put the odds at 1-in-3. If this were to occur, it would be the product of psychology. While some trigger would be required (such as renewed falling house prices), the necessary ingredient for contraction would be the fear that causes households and businesses to cut their spending. Increasing speculation about double dips and deflation runs the risk of becoming a self-fulfilling prophecy if it becomes too intense.
The simple reality is that major imbalances had developed before the U.S. downturn and the policy response has created its own set of complications. These imbalances must be unwound. Unfortunately, it takes time. The country is like a patient after a major operation; it’s now in the process of healing. Policy makers, households, and businesses want the patient out of bed and life back to normal. It simply isn’t possible. An extended period of convalescing is required.
This will naturally lead to frustration and worries about whether progress is truly being made. It will provide fuel for the bears that will augur of terrible times to come. History, however, is not on their side.
Craig Alexander is Chief economist, Toronto-Dominion Bank
