Tuesday, May 12, 2009

Krugman is at it again

Paul Krugman has decided to be the curmudgeon. 

His latest attack of sourness is aimed at the soaring stock market and prospects for economic growth. Krugman has assailed the notion of a 'V'-shaped recovery. He contends that the equity market is priced for that.

This raises several questions. First, the stock market was bludgeoned in recession and in the financial crisis; it made a dive of near historic proportions. All it is doing now is gaining some of that ground back. There is nothing in the market now that makes stocks look like they are overpriced. If you look at the market in its range in this cycle the S&P is up 37% from its cycle lows  yet down 40% from its cycle peak. 

The economy typically goes into recession (a period in which growth slows and GDP generally declines), then has a recovery (a period of stronger than normal GDP growth), then settles into its expansion period in which growth normalizes. Stocks typically drop before and during recession. They begin to rise before recession ends and rise strongly late in recovery anticipating the economic the revival.  Stocks then settle into the expansion period, a period in which they continue to demonstrate cycles.  

It is hard to look at P/E ratios in the business cycle to diagnose the level of the stock market.  In recessions earnings get trashed; in recoveries earnings spurt. Currently, contrary to what Krugman says, about Wall Street's view most analysts are not forecasting a huge boom in earnings over the next 12- to 15-months when the economy should swing into recovery.  

It is probably more accurate to say that the stock market has roared back from its lows because investors have acknowledged that the extreme economic conditions that drove stocks below their proper values no longer are valid. With the Fed and Treasury backstopping banks and with a huge stimulus program kicking in, the extremely low-valued stock market made no sense.

Moreover, since analysts are not projecting strong earnings growth at the company level it is hard to maintain that Wall Street is geared for a 'V"-shaped recovery, as Krugman contends. Krugman is judging from this spurt in the stock indices but forgetting that stocks had to climb out of a deep hole just to get back to neutral. Basically there is very little support for the idea that 'Wall Street' sees a "V'-shaped recovery. Individual company earnings estimates don't look for it, economists forecasts don't look for it and the stock market - as far as it has come - really is not priced for it - yet. Paul simply has this one wrong. 

As to the issue that this will not be a "V"-shaped recovery, that is another matter.   

History shows that we do not and have not had 'V"-shaped recessions without getting "V"shaped recoveries, at least in the Post War period.  Since the Fed/Treasury are backstopping banks, it seems unlikely that the financial sector will backslide and hinder the normal expansion. Krugman has said that talking of 'green shoots' could make policymakers complacent.  On the contrary, some positive talk from policymakers could be very helpful to lift the pall of uncertainty and fear that Krugman seems to relish. 

In this cycle the administration should be pushing optimism much more than it is. The Fed, on the other hand, needs to nurture pessimism and be on guard for backsliding. It does not want to encourage thoughts of a too-strong economic revival as that would put it on the spot early in the recovery. That might suggest that the Fed's balance sheet expansion should be reversed. The Fed does not want to do that until the economy can surely stand on its own two feet. If Krugman refers to this as the risk of complacency, I would agree. The Fed is under a lot of pressure to reverse its easing and its policy of balance sheet expansion.  There is a risk that it might be pushed to unwind its quantitative easing too soon.  

Recessions always breed pessimism just as booms breed optimism. In each environment it is hard to convince people that the regime-du-jour is coming to an end.  Krugman has fallen into the trap of being a recession pessimist. 

The economy does face real challenges; some of of historic proportions. But it has fallen so far below trend, there is so much pent up demand, that once the fear is gone, consumption can once again rise strongly for a period to make up for lost time. What I see is the possibility of some very strong growth over four-to six-quarters followed by a more mature stage of the expansion in which some of these fundamental constraints finally become more binding and restrict growth. At that point sub par growth could become the norm, but not until a rapid economic recovery has first played out.  

Krugman is right to be worried about the drop in home values and in consumer wealth and the shocks faced by the economy which will require rebuilding and reorientation. Business cycles are special periods.  Recession and recovery actions are not driven by the same dynamics that drive trend growth. Recovery periods are periods in which the economy typically 'recovers.' It makes up ground.   Rapid recovery economic growth rates are historically the norm after deep recessions. I do not understand Krugman's opposition to that concept. This recession has been very deep and certainly should spawn a recovery consistent with the downturn.  This recession was not 'dish'-shaped or 'U'-shaped.   It should not generate the type of recovery that past two recessions fostered.   The recession basically determines the shape of the recovery. But the following expansion period is when the fundamentals kick in and they are in need for work in this cycle.   

Despite my forecast of a strong recovery I think the economy remains at risk and if anything, the rapid recovery will increase the possibility of a policy error that could harm prospects for growth in the expansion period that normally follows recovery. A slow recovery will keep all policy efforts focused on nurturing growth; a rapid recovery would foster the sort of complacency that Krugman claims to fear.  

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