Will the economy turn around in 2012?

GDP, economic recover Federal Reserve Bank of San Francisco

With the latest sightings of green shoots in the economy, it's natural to ask how long it will be until the economy recovers. Is an acceleration in economic activity just around the corner? Are we anywhere near the end of the long road back to a more normal economy?

UCLA's Edward Leamer provides a nice summary of the typical way in which the economy exits from a recession. The first and most important two sectors to pick up after a recession are housing construction and household consumption. Once the recovery is fully underway, business investment picks up as well, but that doesn't happen until housing and consumption lead the way.

The problem we face is that the sectors that generally lead us out of a recession are the sectors that were most damaged from the collapse of the housing bubble and the subsequent recession. Housing construction is unlikely to increase anytime soon, and households are still struggling to pay off their debt, debt that was made worse by the unemployment, stock crash, and housing price crash that came with the recession. (The automobile sector is also important in recoveries, but the signs there aren't any better.)

Recessions have different causes, and some types of recessions are easier to recover from than others. An increase in oil prices or an interest-rate hike by the Federal Reserve can be reversed quickly, and the recovery time is generally relatively fast. But as Carmen Reinhart and Kenneth Rogoff explain in their book This Time is Different, recessions that are caused by financial collapses are among the most difficult to recover from. When this type of a recession hits an economy, lost decades are not at all unusual.

Unfortunately for us, both housing markets and household balance sheets were severely damaged by the recession, and repairing them will take time. Housing values remain depressed with no sign of a robust recovery in sight, and households continue with the debt deleveraging process. Neither sector seems poised to lift us out of the doldrums in the near future.

These two graphs give a good indication of where things currently stand:

Is there anything else that could lead us out of the recession? Recall that aggregate demand is the sum of household, business, government, and foreign demand for our goods and services. As just noted, households are in no position to help, businesses -- including housing construction -- are also unlikely to provide the needed boost, so what about government and the foreign sector? Can they provide the needed demand? We certainly can't expect expansionary policy from government, if anything the size of government will contract, and with all the uncertainties in Europe the foreign sector is not the answer either. The Fed is another potential source of help, but it's given little reason to expect it will take additional steps to try to simulate the economy.

In short, no matter which sector you point to, government, business, households, or foreigners, there is little reason to expect the large increase in demand needed to drive an economic recovery. Things are looking better, and the green shoots might just be real this time around, but we are still a long, long way from returning to whatever our new normal might be.

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