He Saw Trouble Coming. Now He Sees It Going.

By GRETCHEN MORGENSON
Published: November 6, 2010


Two data points from last week seemed to indicate an upswing ahead. October’s employment figures rose more than economists had expected, and the stock market clawed its way back to levels last reached just before the calamitous events of fall 2008.

But positive indicators can and do disappoint, so I decided to consult an expert on these matters: Ian Shepherdson, chief United States economist at High Frequency Economics. As a reader of economic tea leaves over the last five turbulent years, Mr. Shepherdson has a darn good record. For instance, unlike the throng of economists who failed to see the housing crisis coming, Mr. Shepherdson warned his clients in fall 2005 that real estate would crash and a recession would ensue.

He was early, of course, and now acknowledges that he was not nearly emphatic enough in his warnings. But he was fundamentally right back then and has been consistently on target since. So, I am happy to report that he sees the beginnings of a turn in the economy that could translate to a rise in gross domestic product growth and an improving employment picture in the second half of 2011.

The basis for his view is a shift, albeit nascent, in commercial and industrial bank lending. The trend is real, he said, and as it gains steam, small businesses should receive more credit, for which they have been starved. And because these companies employ half of the nation’s work force, this credit expansion will translate into real employment gains.

“The depression in small businesses explains pretty much everything in the weakness of this cycle,” Mr. Shepherdson said. “I reckon in the last cycle they accounted for two-thirds of all new job creation. Not only are they big, they are better job-creation engines than big companies, which are more inclined to do their new hiring offshore.”

HERE are the data that have caught his eye. At this time last year, the total stock of commercial and industrial bank credit was $1.32 trillion; it was contracting at a blistering pace — about $7 billion a week. Indeed, between the peak of such lending in October 2008 and the trough in June of this year, total commercial and industrial bank credit fell by one-quarter.

Now, this contraction has stopped. The data have recently turned positive and should continue climbing, albeit slowly. “Getting to zero is not bullish at the moment,” Mr. Shepherdson said. “I would want to see commercial and industrial credit growing reasonably strongly to an outright positive four, five or six billion dollars a week. The story is really that the credit contraction seems to be coming to an end.”

One problem for economists and investors, he said, is that our current economic cycle does not have the typical recession-recovery characteristics or timeline. Those who thought it would be similar to recent recessions were trying to fit a square peg into a round hole; there was nothing normal or routine about the events we have just lived through.

But Mr. Shepherdson says he does find parallels in our experience and that of Sweden in the early 1990s. The expansion of bank credit before the peak was similar in both countries. Furthermore, Sweden’s boom, like ours, resulted in rocketing real estate prices and overleveraged consumers.

When the bubble burst, both countries experienced similarly awful contractions. Gross domestic product declined 5.1 percent in Sweden at the trough, compared with 4.1 percent in the United States.

Mr. Shepherdson hopes that the Swedish experience on the upside also repeats itself in the United States. After Sweden’s output bottomed out in early 1993, the country began an upswing that soon became supercharged. The initial growth was at an annualized rate of 2.5 percent, but by the second year of the rebound, G.D.P. growth was 5.3 percent, annualized.

We may not end up with a recovery that hot, Mr. Shepherdson said. But if the credit expansion he is expecting does transpire, he said, we could achieve annualized growth of between 3 percent and 4 percent in the second half of 2011. And the year after that looks even more promising, he said, because “credit conditions will be back to something like normal.”

He expects that in the meantime, we will bump along at around 2 percent in economic growth, with no double-dip recession.

As commercial and industrial credit eases up a bit, Mr. Shepherdson said, it will unleash a pent-up demand among smaller companies for capital equipment, software, vehicles and other goods.

“We have seen strong capital spending in the gross domestic product accounts, but that’s all been big companies,” he said. “The next step is for small companies to pick up their buying and start hiring people.”

This lag in small-company spending is all about the tight credit conditions in that sector. The divergence between the amount of credit extended to big and small companies, he said, shows up in the distressingly wide gap between two closely watched sentiment surveys: the reports from the Institute for Supply Management, which reflects manufacturing activity of larger enterprises, and from the National Federation of Independent Business, representing smaller companies. While the I.S.M. figure is in recovery mode, the N.F.I.B. statistic remains squarely in recession territory.

Obviously, a growth in lending to small businesses is not yet being felt across the board, Mr. Shepherdson said. But as the credit expansion trickles down to these companies, the gap will start to close and employment will begin to ramp upward.

“My overwhelming condition for things to get better in the small-business sector is credit, so the positive data are a hugely exciting development,” he said. “I don’t think we will see all these gaps close by December, but over the next 12 months I think we will see a transition out of a sluggish 2 percent economy to a real, properly growing recovery. And the second half of 2011 may be the true turning point for unemployment.”

THERE’S no denying that our long economic despond has hurt vast numbers of people nationwide. And Mr. Shepherdson cautions that good times aren’t likely to roll immediately. “I wish it would be one of those situations that fixes itself in three months, which would be a normal cyclical rebound,” he said. “But by August of next year there is a very good chance that we will be on a recovery path.”

Let’s hope he is right again. And let the countdown begin.