Now is the middle of second quarter earnings season. According to Bloomberg, out of 54 companies which reported their earnings, only 10 fell short of expected EPS by analysts. Fairly bullish view one might say, but not under current circumstances. In the face of double dip fears investors are switching their minds quickly. Market is searching for weakness in published second quarter data absence of which would be a proof that economy is recovering. Although companies on average have reported that their profits are higher than expected, revenues were below of expectations. Profits in this quarter came mainly from cost cutting. This makes investors worry about corporate profits in the coming quarters. What if consumer spending doesn’t pick up, will corporations be able to generate profit through cost cutting further?
Downtrend since May in S&P 500 index shows that market prices in double dip scenario. But volatility suggests that market doesn’t really know yet how much to price in.
Double dip it seems is a threat mainly to developed countries such as the USA, Japan, UK, France, Germany etc. Firstly, because some of the emerging economies didn’t experience even “first dip”, for instance China, where the lowest point was GDP growth of 6.2%. Secondly, developing countries are recovering much faster. As estimated by IMF in World Economic Outlook Update (July 2010) Brazil will grow 7.1%, while the growth rate for Euro area is projected at 1.1% in 2010.
Paul Krugman, Nobel-prize winning economist, warns that what we see now in the world’s economy can easily be turned into “Third Depression”: so severe recession that it can be compared with Long Depression of 1874-1879, and Great Depression of 1929-1931. The main mechanism that can threaten economic recovery is inappropriate economic policy. In both Long and Great Depressions slump was not uninterrupted, there were occasional bounces in GDP, which fooled authorities into believing that recession is over. Recent economic growth probably is just such bounce. Krugman argues that recent growth in GDP is mainly driven by “inventory bounce” and fiscal stimulus, factors that don’t promise sustainable recovery. “Inventory bounce” happens when demand has declined and companies are left with excess inventories, they decrease production to get rid of stored goods, when inventory is disposed firms increase their production resulting in a “nice” growth rate.
For example fiscal stimulus in the USA highest impact on growth rate has already shown in the middle of this year and now its effect is disappearing. Governments around the world are reluctant to engage in second stimulus wave instead they are obsessed with austerity measures. Fears of debt problems: Greece-type crisis, motivate governments to start spending less and taxing more in a situation where private consumption growth is still fragile. Is it right or wrong?
There are two sides in the current situation. Some including Jean-Claude Trichet, president of ECB, argues that lower budget deficits will “restore confidence” in the economy thus fostering recovery. Others, for example Paul Krugman, says that governments are acting too early in withdrawing stimulus and this will clearly be contractionary. The case here is quite tricky to say the least. It seems that the real question is how credible countries will manage their debts while handling the crisis.
Trichet argument might be true if higher stimulus would automatically cause higher interest rates and government debt snowballing. Here stimulus would crowd out investment spending and consumption of durable goods significantly, run on banks might take place. But it’s hard if not impossible to assess the impact of each effect. The main question with this argument is if governments decrease deficits and if interest rates in fact go down will that create such a big confidence in economy that increase in consumption and investment will offset government spending cuts? This seems very like self-fulfilling expectations; if ECB can convince enough people to believe in such mechanism then people’s actions on such beliefs will make mechanism true.
On the other hand Krugman`s text-book type argument seems very reasonable as big part of the world is in liquidity trap (short term interest rates are virtually zero) thus making fiscal expansion very effective. This argument becomes even stronger if one looks in corporations’ balance sheets, which have loads of cash savings corporations don’t want to invest in real economy.
There is yet another important and difficult economic policy issue from the side of monetary policy. When is the right time for central bankers to pump out liquidity that was thrown in the system to fight with the crisis? If it’s done too early it may send economy back into recession. If it’s done too late there are threats of high inflation.
So with what we are left. Consumption growth is still fragile. The rise in investment spending is somewhat limited as there is already much of excess capacity. Net exports for the world are 0 nothing to take from there unless we start trading with aliens. Economic policy becomes crucial here. It is probably not even what governments do but the quality how they do that is important.
