Thursday, November 13, 2008

How Much Pain?

Much coverage this morning of the latest Bank of England Inflation Report. In particular, their big dipper GDP forecast (above). Unfortunately - scary though it looks - it seriously understates the likely pain we face.

The Bank forecast envisages a short sharp recession, with a maximum total fall in GDP in the range 2-3%, and recovery back to the starting GDP level within about two and half years (ie late 2010). But previous recessions since WW2 have been worse than that, and they weren’t triggered by the worst financial crisis in history.

The following chart shows what happened to GDP in the three previous recessions, tracing the quarterly path from the onset of the downturn through to the quarter in which GDP recovered back to its starting level. The conventional definition of recession emphasises the down leg – the quarters while GDP is actually contracting – but it’s also important to remember we still remained poorer right up to the point when we’d clawed back the whole loss.

As we can see, the shortest of the recessions was the first, which lasted from 1974 to 1976. At its worst point, GDP was a chunky 4% below the starting level. The slide was triggered by the first oil price hike, although with our "sick man" economy and chronically lax fiscal and monetary policy, we'd been an accident waiting to happen. It culminated in the collapse of sterling and the humiliation of the IMF loan, with Uncle Jim Callaghan telling us in all candour that we could not spend our way out of recession.

The second shortest was the 1990-93 recession, and interestingly, it was also the shallowest: the maximum GDP loss was "only" 2.3%. The problem, and why it felt so much worse, was the length of the down leg. It was drawn out over a miserable two years, which rendered Norman Lamont’s constant "green shoots" refrain sound ridiculous and even insulting. It took over three years to get back to our starting point.

The worst post-WW2 recession by far was 1979-83. At its trough, nearly two years in, GDP was down by more than 6%, and it took an extraordinary four and a half years to recover back to our starting point. It amply explains why Thatcher will always be seen across large swathes of Britain as the epitome of evil.

Now, all three of these recessions were different, but taken together they do suggest the Bank’s current forecast is optimistic. So what’s going on?

The answer is that the Bank is assuming... hoping we'll be saved by the massive fiscal and monetary boost now underway. And indeed that is very different from the policies in place during the previous recessions. On all three previous occasions, policy had to be kept tight to whack domestic inflation, and (in the 70s and early 90s) to defend the pound.

Will the Bank's hopes pan out?

Nobody knows. But with our busted banks, and our animal spirits gone walkabout, we're not holding our breath.

The 2010 election will be held in a world of pain. A world in which the winner will scratch around vainly for any growth to share.

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