As I noted here, pretty much everyone who has had the temerity to publish a forecast for the Canadian economy for 2009 is expecting a turning point in 2009Q2 or 2009Q3. In this post, I'm going to try to piece together the narrative behind this story. I'll be borrowing heavily from Calculated Risk: if you're going to copy answers, make sure to sit next to someone who has done their homework.
The obvious place to start is the US housing market: when it starts improving, it'll take many other things along with it. If you've only recently started to pay attention to this story, the idea that things could turn around in six months seems very bizarre: doesn't it take years for housing markets to adjust? They do indeed - and US housing prices hit their peak three years ago. Since then, new house sales have fallen off a cliff. But since housing starts have fallen even faster, inventories are starting to be absorbed. It can be reasonably expected that US housing starts will level off sometime this year, if for no better reason than the fact that they can't go negative. And as the inventories get worked down, prices should stop falling.
Next up is auto sales. In this post, CR offers this graph along with this comment:
Currently this ratio is at 23.9 years, the highest ever. This is an unsustainable level (I doubt most vehicles will last 24 years!), and the ratio will probably decline over the next few years. This could happen with vehicles being removed from the fleet, but more likely because of a sales increase.
If the ratio of vehicles to licensed drivers declined to 1.1 (last seen in the early '90s recession), and the turnover ratio declined to 15 years, this would suggest sales would increase to 15 million vehicles per year. Although not as high as the recent boom years - this is still a sales increase of more than 40% above current levels.
Neither of these stories requires the reader to be in an optimistic mood to believe them; both are saying "things cannot get worse than zero, so they will stop deteriorating soon". And the basic arithmetic of stocks and flows seems to be enough for US forecasters to predict that the US economy will stop shrinking in the second half of 2009.
I suspect that many readers would expect me to stop here: once we've established a US trough, it obviously follows that Canada will also snap out of recession, right? Well, no, it doesn't - no more than it obviously follows that Canada will always follow the US into recession. Think of the 2001-2 US recession: an episode that hardly affected Canada. What we have to do now is trace through the mechanism of how events in the US will affect Canada.
It's been noted here at several points over the past few months that the driving force behind the recently-deceased expansion was an increase in consumer spending, and that this increase was generated by higher incomes produced by the improvement in Canada's terms of trade generated by rising prices for oil and other commodities [Good lord. Has a clumsier sentence ever been written? - ed]. The reason that Canada didn't follow the US into recession at the end of 2007 was that commodity prices were still high through 2008 up until the financial crisis.
When financial markets seized up, we were hit in two ways:
- Industries in which purchases are financed by consumer credit saw a drop in demand. Even if households were interested in buying, vendors no longer had access to enough capital to provide financing. (Think of the auto sector here.)
- Importers were no longer able to finance purchases of imports on the basis of anticipated sales, so international trade volumes - and oil and commodity prices - tanked.
When oil and commodity prices collapsed, the source of Canada's real income growth went with it. (Parenthetically - and is there any other sort of comment that goes in parentheses? - this sheds some light on why the Bank of Canada was so quick to declare that we were in a recession after the release of November's employment numbers. Ordinarily, there would be an interval in which in which we would all be cautioned to not put too much weight on one employment report, that we should wait for a clearer picture, yadda yadda yadda. But this time, the Bank knew that the last support for the Canadian economy had been kicked out from under it, so there was no hesitation in calling the October turning point.)
Happily, we are starting to see some evidence that the credit crunch is easing: the TED spread (the difference between the inter-bank rate and the yield on T-bills) is now back to not-too-far-from-normal levels. There could be another hidden time bomb out there that might blow things to pieces, but then again, has there ever been a moment in our history in which that was not the case? And even if that unhappy eventuality should come to pass, central banks around the world are now acutely aware of the importance of avoiding another Lehman Brothers-type meltdown and will do whatever it takes to prevent credit markets from seizing up. No-one will be worrying about moral hazard for a very long while.
So this is what the story looks like:
- US housing starts will hit bottom sometime around the middle of 2009.
- Credit conditions will continue to ease.
Put these two together - along with the prospect of a recovery in US auto sales - and you can start to piece together a scenario in which the US economy turns the corner, world trade recovers, and commodity prices get back on the path that Hotelling foretold for them. In other words, the major ingredients of a Canadian recovery.
Have you been watching the TD Economics daily and weekly financial indicators? Top right corner of http://www.td.com/economics/ . They tell the same sort of story for Canada, though a slight worsening of spreads in the last couple of weeks.
Posted by: Nick Rowe | February 08, 2009 at 10:40 PM
Nice argument, I hope you're right ;)
Posted by: Kosta | February 08, 2009 at 10:43 PM
"enough for US forecasters to predict that the US economy will stop shrinking in the second half of 2009"
Is this the best we can hope for ?
Posted by: learning james | February 09, 2009 at 05:13 PM