Sunday, July 05, 2009
Honda effect suggests we are out of the dive
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

honda.jpg

When people say to me they are confused about what is happening in the economy, I am not surprised. For weeks the talk has been of the recession ending and the possible start of recovery.

Then along comes the Office for National Statistics with an eyecatching set of data revisions and we are apparently back mired in the sharpest downturn on record (the ONS’s quarterly gross domestic product records go back to the mid-1950s) and the biggest quarterly drop in GDP since the second quarter of 1958.

The key point is that last week’s figures, which were published on June 30 (the end of the second quarter) were a revised estimate of what happened in the first quarter.

The first three months of the year are not exactly ancient history but they came ahead of data and surveys suggesting the economy has begun to stabilise. So the scary ‘slump’ headlines on the back of the ONS’s third guess at first quarter GDP were consistent with the recovery headlines that came after the following day’s purchasing managers’ index, which suggested Britain’s troubled manufacturing sector is close to the end of its recession.

As an aside, older readers may be surprised to learn that 1958 saw a bigger quarterly fall in GDP than the 2.4% plunge we have just had. This was the post-war golden age for the economy, the Harold Macmillan “you’ve never had it so good” era.

It was also, however, the stop-go era, in which one-off falls in GDP were common, though not on that scale. People forget, too, that Macmillan’s immortal phrase, which was actually “most of our people have never had it so good”, uttered in July 1957, was intended to reassure a public far from convinced about his government’s economic management. A sterling crisis in September of that year had to be met with a sharp rise in interest rates. Something must have worked; he was re-elected two years later.

The ONS has reignited the debate about the severity of this recession compared with its predecessors. Any doubt about whether this is worse than the early 1990s has been erased; the peak-to-trough fall in GDP then was a mere 2.5%, only slightly more than in the first three months of this year alone.

Is it worse that the recession of the early 1980s? Then, British manufacturing was more than decimated; it lost a fifth of capacity. The severity of that recession is open to some statistical debate but if you measure the drop in GDP from its peak during 1979 to the 1981 trough, it was 5.9%, compared with 4.9% so far this time. So my view is that this is not as bad yet, though whether it gets that bad depends on the next couple of quarters. Economists are looking for a flattish second quarter, with some even predicting a rise. We will get a first look at the numbers on July 24.

I shall repeat the point about it being impossible to judge how serious this recession is compared with its predecessors until we have been through many data revisions from the Office for National Statistics. At this stage, much of the information about the first quarter remains much more tentative than the precision of the ONS figures suggest. There is a lot of guesswork and modelling in these numbers.

Revisions will not see the recession melt away but they may make it look different. Take 2005. At the time this was thought to be the year when Britain stopped. Economists believed growth had slumped to 1.5% or less. Now it is 2.2% and rising.

In the last recession of the early 1990s, the Treasury late in 1992 was working on the assumption that the economy shrank by 2.5% in 1991, slipped by a further 1% in 1992 and would grow 1% in 1993. The figures now for that period are -1.4%, 0.1% and 2.2% respectively.

But we have to work with the material we have now until those future revisions come along. What do the numbers tell us?

They confirm the role of inventories - stocks - in this recession. Mervyn King calls it “the Honda effect”, a slogan the company has taken to using in its advertising. Honda chose to supply customers from stock, shutting down production at its Swindon factory. Last month it restarted.

In the eye of the recessionary storm, the six months from October 1 to March 31, GDP fell by 4.2%. Of this nearly half, two percentage points, was due to the rundown of inventories. At some stage that will be reversed, and it is probably happening already. If it occurred quickly it could produce an unusually strong but short-lived bounce in quarterly growth.

As it is the first quarter figures have not changed the view of most economists that the current quarter will see only a modest GDP decline, or better. That is partly based on the view that the inventory cycle has turned, a view supported by purchasing managers’ indexes for Britain and other countries. The GDP figures tell us it was a steep bungee dive. Subsequent information tells us we have stopped diving.

Amid the wreckage there was another encouraging feature in the GDP figures, highlighted by Michael Saunders of Citigroup. Companies and households, the non-bank financial sector, had a financial deficit 0f 0.9% of GDP as recently as the third quarter of 2007. Now they have a surplus of 7.9% of GDP, a rapid turnaround.

According to him: “This is the highest since detailed data on private savings began in 1987, while partial data suggest private savings are now the highest since 1980.” One of the stories of the recession has been about the need for the private sector to undergo a painful adjustment process. For the financial sector that process has a long way to go.

But for companies and individuals, the new numbers are encouraging. They suggest, according to Saunders. “the main part of the inevitable adjustment is probably behind us”. For firms more interested in seeing their customers spend than save that has to be good news.

PS: With Bank rate stuck at 0.5% and unlikely to change for quite some time, you could be forgiven for thinking that this week’s meeting of the Bank of England’s monetary policy committee (MPC) will be a non-event. Not so.

The big decision is whether to announce a further increase in quantitative easing (QE) from the £125 billion so far agreed upon. On the present timetable, the Bank will get to £125 billion of asset purchases before its August meeting, implying it needs to decide this week whether to go further, to the £150 billion limit it has so far been given by the Treasury. Some on the MPC think, however, it would be better to wait until the fuller discussions it is able to have around its new projections in the August inflation report.

The shadow MPC, which meets under the auspices of the Institute of Economic Affairs, has few qualms about continuing with QE, which it advocated before the Bank adopted it. Most of its members think interest rates should be held at 0.5% and the Bank continue with roughly £25 billion a month of QE until the effects are more clearly showing through, even to the point of adding between £100 billion and £150 billion to the total. It is, says the shadow MPC, “the only effective monetary policy instrument presently available to the authorities”.

QE is manna from heaven for monetarist economists, who are well represented on the shadow MPC. Tim Congdon thinks it saved Britain from a monetary collapse on a par with the Great Depression but is concerned that so much of the money being created is staying in the financial sector. Gordon Pepper thinks the pace of QE has been about right while Patrick Minford warns against premature exit strategies from the policy.

In the markets, there is a debate about whether this “unconventional” policy from the Bank will be inflationary. For me, much more debate is whether it will work in boosting the economy. We still cannot be sure of that.

From The Sunday Times, July 5 2009