Do economies have a “stall speed” below which their growth engines sputter and die, tipping them into recession? This question is being asked about the US economy, whose quarterly GDP growth has dipped from two per cent on annualised basis in the first quarter to 1.5 per cent in the second. The US economy has dipped into recession on a number of occasions after it has decelerated to a 1.8 per cent quarterly growth. Will this happen again?
The “stall speed” metaphor is drawn from aviation. Aeroplanes need to fly at a minimum speed to stay airborne. This is their stall speed. Extended to economies, it suggests that economies need to grow at a certain minimum rate to avoid tipping into a phase of decline or recession.
Paul Dales, an economist with economic think-tank Capital Economics, points out that while the metaphor might seem elegant, the theory underpinning it is somewhat fuzzy (“The economy does not have a stall speed” July 30). Those who believe that the metaphor actually works argue the following: the fall in GDP growth below a threshold level dents confidence of both firms and consumers. Firms cut back on hiring and investments while households hold back on discretionary spending, which sets off a vicious cycle that tips the economy into recession.
Dale argues that a sharp slowdown in economic growth after a period of rapid growth could presage a recession. When the economy grows above potential, a stage comes when excesses need to be worked out of the system. As companies and consumers hit the brakes, the economy initially hits a stall speed and then tips into recession. To use jargon, the probability of a stall speed and recession is high when there is a positive output gap.
However, as Dales points out, when households and firms are spending just to meet day-to-day requirements, the need to cut back sharply on hiring or investment and discretionary spending is low. Thus, even if it initially appears to have hit a stall speed, an economy could well cruise along at this speed without falling into a recessionary trap. Empirical data seem to support Dales’ case. Since 1950 the economy has dipped below the threshold speed of 1.8 per cent 18 times. During 10 out of these 18 times, the economy slipped into recession. However on nine out of these 10 occasions when the economy hit a stall speed and then plunged into recession, the economy was operating well above capacity. On five of the eight occasions when the slowdown to 1.8 per cent was not followed by a recession, the economy was operating much below capacity.
In short, the deceleration itself in the US might not mean that the economy is moving back into recession, given the fact that it is operating well below potential. However, there could be shocks to the economy that might lead to a fall in economic growth. If, for instance, there is a political impasse over the measures needed to prevent the “fiscal cliff” that the US faces in 2013 (a combination of sharp expenditure compression and expiry of tax cuts that add up to about four per cent of GDP), there is a risk of recession. A meltdown in Europe could also induce a recession in the US, given the extensive trade and financial linkages between the two regions
One could perhaps extend Dales’ argument to the Indian case. Despite the deceleration in growth, the Indian economy might not necessarily face the prospect of continuously declining growth rates in the future. The Indian economy is operating well below its potential; its “output gap” is deep in the negative zone. A growth rate of around six per cent that the economy is likely to see this year could be the bottom of the cycle (in India’s case, a drop in growth to five per cent would perhaps qualify as recession). The economy could stabilise at around six to 6.5 per cent in the medium term.
However, like the “fiscal cliff’ in the US, there are one-off risks with which the economy needs to deal. Fiscal consolidation seems to have gone into the cold storage. That could mean ratings agencies could downgrade India’s ratings in the near future. This could entail a massive draft on external resources that would ultimately push growth down sharply.
Tailpiece
The somewhat insipid policy announcement from the European Central Bank (ECB) on Thursday after some inspired tough talking by ECB chief Mario Draghi has led to considerable disappointment in the markets. This might just be the theme going forward when despite promising rhetoric, the actions taken on the ground might keep falling short of expectations. This could breed a risk-off environment that keeps the pressure on non-dollar currencies alive. Combine this with event-specific risks, such as a rating downgrade or fresh concerns about Greece exiting the union or Spain going bust, and the probability of another round of sharp depreciation in the rupee increases.
The author is with HDFC Bank. These views are personal
