Don't count on a 'normal' recession

By Jim Jubak

The stock market doesn't much care whether a 2008 slowdown in the economy is an official recession or not. As far as Wall Street is concerned, there's just not much difference between economic growth falling to 1% or to minus-0.5%.

As long as the slowdown, recession, whatever, is short. No more than two quarters. Over and done with by mid-2008. Then the economy and the stock market, Wall Street believes, can look forward to another long boom.

That's why global stock markets recovered so quickly after the Federal Reserve cut short-term interest rates by three-quarters of a percentage point in a surprise move before the market's open Tuesday. What had been near panic on global exchanges Monday and early Tuesday turned into a rally by Wednesday because Wall Street still believes the Fed, the White House and Congress can keep the U.S. economic downturn short.

Recent history supports that view. Over the past two decades, recessions have been remarkably short and remarkably mild. If any 2008 recession is a "normal" one, investors are absolutely right to look past it to an economic recovery in the second half of 2008.

Disappointing odds

But what if a 2008 slowdown or recession isn't normal? What if it drags on for 12 months and not just six or eight? Then the stock market has set itself up for serious disappointment, with multiple dips in the major averages as investors gradually realize that 2008's economic slowdown will be lengthier than expected.

The odds of that kind of disappointment in 2008 are, unfortunately, high. This sure doesn't look like the "normal" recession. Because so many consumers got used to drawing against their rising home equities to fund their spending, the bursting of the housing bubble and the crisis in the subprime-mortgage market have resulted in far more damage than usual to consumer cash flows. The drop in consumer demand is well beyond what you'd expect in an economy that's still producing jobs at a decent rate.

Even with personal income rising at a 6% annual nominal rate -- that's before subtracting inflation -- consumer spending has started to slow. If employment growth drops, as the Federal Reserve projects in 2008, then the drop in consumer spending could well accelerate. And at the current rate of progress in the housing market, it's going to take way more than a couple of quarters to repair consumer balance sheets damaged when the bubble burst in 2007.

The bad old days

A 2008 economic slowdown or recession wouldn't need to be one for the record books in order to disappoint Wall Street. It could simply mark a return to the bad old days, from 1959 through 1983, when recessions lasted 50% longer, were nearly twice as severe and took place about twice as often.

A September 2007 report from the Federal Reserve Bank of Dallas summarizes the difference between a recession in the bad old days and now:

"On average, the five recessions from 1959 to 1983 were 47 months apart, lingered 12 months and were associated with a 2.17 percent peak-to-trough decline in real gross domestic product. By contrast, the 1990 downturn came after 92 months of expansion, lasted eight months and involved a 1.26 percent decline in GDP. The 2001 slump ended a record 120 months of uninterrupted growth, lasted eight months and entailed a GDP decline of only 0.35 percent."

Economists first picked up this shift to shorter, less severe and less frequent recessions in the late 1990s. Since then, they've been working hard to explain why the economy is behaving this way. Explanations for what has been dubbed the Great Moderation include:

• Structural changes in the economy, such as "just in time" production systems that prevent a big buildup of inventories that can result in a slump in new orders as companies work off old stock.

• Financial innovations, such as home-equity loans that smooth the swings in consumer buying that can result from dips in personal income and employment.

• The creation of global markets for raw materials, including labor, goods and services, that smooth out shifts in the growth rate of any individual economy.

It's the second and third of those three possible causes for the Great Moderation that form the crux of Wall Street's hopes for a quick and shallow downturn. Yes, it's absolutely true that the surge in mortgage refinancing and home-equity lending fueled the boom in U.S. consumer spending that drove not only the U.S. economy but also the world economy.

Continued: Global insurance policy

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