Barn Sour

The Lehmann Letter ©

There’s a general consensus that we’ve hit bottom and the economy will now recover. But recovery is not synonymous with rebound, and the key question remains: How swiftly will the economy snap out of recession?

Take a look at the consumer-price-index, interest-rate and housing-starts charts before 1990. Notice the strong inverse relationship between interest rates and residential construction.

Consumer Prices
(Click on chart to enlarge)

(Recessions shaded)

Federal Funds Rate
(Click on chart to enlarge)

(Recessions shaded)

Housing Starts
(Click on chart to enlarge)

(Recessions shaded)


The Federal Reserve let interest rates fall whenever inflation subsided. Building activity immediately expanded, stimulating the entire economy. But escalating inflation soon prompted the Fed to raise interest rates and constrict residential construction. That depressed the economy and instigated recession. Inflation soon shrank, leading to a new round of rate cuts and building activity.

Think of that economy the way you’d think of a frisky horse. The economy broke into a gallop (boom) as soon as the rider (the Fed) let the reins dangle (low interest rates). But the economy came to a halt (recession) when the Fed pulled back on the reins (high interest rates), only to shoot forward again when the Fed relaxed its grip. Consequently those recessions were V-shaped, with sharp downturns and equally sharp recoveries.

The 1990-91 and 2001 recessions departed from this stereotype. The 1990-91 recession is associated with the first Persian Gulf War. That downturn came to an end when soaring computer and software expenditures led to the 1990s dot-com boom. The dot.com boom collapsed when full employment boosted wages and salaries, thereby constricting profit margins and business capital expenditures.

The Fed, in a traditional response, depressed interest rates from 2000 through 2003. The consequent real-estate bubble, and that bubble’s demise, led to the current recession. Once again the Fed dangled the reins, hoping the horse would gallop forward. But this horse remains exhausted from its 2002 – 2006 run. It’s barn sour and requires rest. It won’t break into another run for quite a while.

Tumbling real-estate is at the heart of the present crisis, and falling interest rates will not pull us out. Building won’t recover until the foreclosures cease and home prices stabilize. When the number of vacant homes begins to dwindle, builders’ confidence will return and construction will start to recuperate in earnest.

That means we can’t expect another V-shaped recovery. Right now we’re on the horizontal bar of an L, hoping at some point it will turn into a U. If rising real estate won’t pull us out of the ditch, what will?

Technology? It pulled us out of the 1990-91 slump. Unfortunately there’s nothing on the immediate horizon that resembles the PC and internet revolution of the dot-com boom.

Government stimulus? It will definitely start the recovery, and we’re much better off with it than without it. But it is not and will not be large enough to restore full employment. For that to occur, the private sector must come back and right now there are no signs that the private sector will snap back the way it did so many times before.

The horse is in the barn.

(The charts were taken from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

© 2009 Michael B. Lehmann