Economic upswings don’t die of old age. They end because a cleansing recession is needed after the exuberance of a boom or because an external shock deals a devastating blow to the system. Across the Western world, we find no convincing evidence of serious excesses that would have to be corrected by a downturn soon. Last year, the major Western economies expanded roughly at their trend rates with GDP gains of 2.4% in the US, 2.2% in the UK and 1.5% in the Eurozone. Trend growth is normal. It does not require a correction. Instead, it can continue until something goes seriously right or wrong. No party, no need for a hangover. More precisely, we find seven reasons why the Western world will probably not fall into a new recession soon.
1. No excess investment. Business investment in the Western world has lagged well behind its usual cyclical dynamic in the post-Lehman upturn. Companies still think twice before they dare to commit serious amounts of money to long-term fixed investment. That is a key reason why the cyclical upturn has been less vigorous than usual. But it comes with an upside: the risk that businesses in the developed world have built up serious overcapacities in recent years that would now require a period of offsetting underinvestment looks small.
2. Solid household finances. Scarred by the prior boom-bust experience, households have improved their balance sheets. In the Eurozone, bank lending to households has risen at an average annual rate of just 0.2% since mid-2011, well behind the subdued 1.2% average annual gain in nominal consumer spending. In the US, households reduced their ratio of financial obligations to income from a peak of 18.1% in late 2007 to 15.3% in mid-2012 and have kept the ration roughly stable since then.
3. No credit boom, no cause for a bust. Credit growth in the developed world ranges between normal (US) and still tepid (Eurozone). Even the rebound in housing markets in the US, the UK and Spain is less fuelled by credit than in previous upturns. Instead, households, companies and banks have built up liquid reserves. As a result, they can stomach some turbulence better than in the past. They need not react to financial turbulence with an attempt to reduce leverage in a rush, curtailing their spending as they do so.
4. No inflation dragon to slay. Wage pressures remain modest. As households are not on an excessive spending spree, we find no clear evidence of serious demand-pull inflation either. Technological advances and the return to affordable energy also help to keep inflations risks under control.
5. Central banks can act as the big buffer. No serious inflation pressure, no major excesses or bubbles blown up by excessive credit growth. This has one major consequence: central banks can focus on keeping the real economy on an even keel. If they tighten policy, they can do so at a pace that does not jeopardise the upswing; if an external shocks threatens the upturn or if turmoil in financial markets or losses in parts of the banking system impair the transmission of a monetary impulse to the real economy, they can scale up their stimulus to offset that.
6. Cheap oil helps. It enhances the growth potential of the world economy. The world has more energy it can use at affordable prices. Of course, like all major economic changes, the plunge in oil prices causes some temporary frictions first. Losses for oil producers are concentrated and very visible. The much bigger gains are far more widely dispersed and will take time to be fully felt. The result can be a J-curve. At first, concerns about the losers of cheap oil dominate. But over time, the bigger gains for the global economy will become apparent. Cheap oil also redistributes some demand gains from the manufacturing to the service sector. The losers are mostly in countries far away from us. They import goods from us and now have to slash their purchases drastically. The gainers are mostly consumers at or close to home. We often sell more services than goods to them. The re-distribution of purchasing power from overseas to domestic consumers may thus benefit our restaurants more than our producers of investment goods. Focussing on data showing roughly industrial stagnation in major parts of the developed world overstates the short term friction stemming from the decline in oil prices.
7. Once bitten, twice shy. Markets tend to react to adverse news as if the next big crisis may just be around the corner. But the regulators and policy makers have also drawn their lessons from the post-Lehman and euro crises. They are likely to be more vigilant against any potential systemic risks than they were before. As a result, the risk that modest problems (the short frictions caused by the plunge in oil prices, losses for some banks or for investors in high yield or emerging market paper) would be allowed to escalate into a systemic crisis is probably smaller than it used to be.
Economic data are volatile, market turbulence can itself weigh on some economic indicators for a while. But we see no reason for a recession in the developed world. The slowdown in China and the recessions in some emerging markets dampen the export outlook and weigh on export-oriented industry. But by and large, we see this as a factor that will, for the time being, prevent the acceleration of real economic growth that would otherwise be the result of the positive oil supply shock. Short of a major policy mistake, demand growth in the developed world should remain roughly on track or return to it after a brief dent. In theory, escalating financial panic could trigger a more serious economic downturn. While that is not impossible, it does not look likely.