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Recessions Difficult to Quantify

The Providence Sunday Journal Money & Business Section
March 2008


   by Leonard Lardaro



Rhode Island is currently in a recession that began late last summer. There is ever-growing evidence that the US is either in a recession now, or that it will fall into recession within the next few months. Why is there still a question of whether a national recession exists? To understand this, it is necessary to move beyond several widely held myths concerning national recessions.

Myth #1: A recession is defined as two consecutive quarters where real GDP (national output) declines. If only things were that simple! All anyone would have to do would be to follow the GDP releases and keep score. When the tally reached two – Bingo! Unfortunately, a much more convoluted definition is used by the National Bureau of Economic Research (NBER), the group who ultimately decides if an when recessions occur. The definition they use is: “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Operationally, how should “significant decline” be defined? What about “lasting more than a few months?” The NBER actually relies on monthly data for much of this call. The “real GDP” part is not the primary indicator. For the last recession (March – November 2001), it was our moving past an employment peak that was decisive in their recession call. A two consecutive quarter decline in real GDP didn’t occur!

Myth #2: Recessions are long and deep. Collective wisdom is that recessions are always very serious and they last for a very long time. Through time, recessions have become shorter and less severe. In fact, the last recession, in 2001, was not that deep in terms of lost economic activity (real GDP), and, it didn’t last a full year. What many fail to comprehend is that recessions have stages. They begin when economic activity (however defined) peaks and continue until activity reaches a trough. So, in the early stages of a recession, economic activity remains fairly close to its peak level. This makes the recession call difficult for many. They typically state that if the levels of key economic variables are still fairly high, how can we possibly be in a recession? Economics, like forecasting, is largely about rates of change. So, it is the rate of change in activity that gauges the problems that are occurring. That is why economists so often seem at odds with the public’s views about economic activity. And, when focusing on changes in rates of growth, it is the rate of change in the rate of change that matters! It is only in the later stages of a recession, when the recession has become well entrenched, that we move to levels of economic activity that are noticeably worse than they were at the peak. It is activity levels near the bottom (trough) that most people think of as defining recessions.

Myth #3: Recessions always lower or eliminate inflationary pressures. This was true in the “good old days,” before the advent of OPEC. Back then, inflation fell during recessions, as it was caused by excessive demand growth (called “demand-pull” inflation). Starting in the early 1970s, with the appearance of OPEC, we experienced recessions where inflationary pressures didn’t recede (called “cost-push” inflation). That combination, recession and inflation, is called stagflation. Many “talking heads” on television believe that stagflation has returned. But, the actual definition presupposes far more serious declines in economic activity than we will now witness. At any rate, this combination is very problematic for the Federal Reserve. If it moves against inflation, as it did earlier, economic growth suffers. If it chases economic weakness, as it now appears to be doing, inflation tends to accelerate.

Myth #4: If people would stop being so negative, we could avoid a recession. While negativity can move an economy into a recession when it is close to falling into a recession, there are almost always other forces at work. At present, globalization is very critical: will our weakness cause other countries to grow slower or have recessions? It appears that we are already witnessing this to some extent. Should foreign economic activity remain fairly healthy (called “decoupling”), declines here will moderate. So, even if we close our eyes and make a happy wish, globalization has changed things so that the US is not entirely the master of its own fate.

Let me conclude by making two points. First, recessions serve a macroeconomic purpose – they force firms and industries to be more efficient and thus profitable. Those either unwilling or unable to make required changes are ultimately forced out of existence. While this is not necessarily fair, losses serve an economic function – they free resources to move toward their more highly valued uses. Finally, measurement complicates recession calls. While weather forecasters are able to look outside to see the exact conditions that exist, economists don’t have that luxury. Data revisions, problems with seasonal adjustment, and the way our transition to a service-based economy has skewed the “traditional” patterns makes assessment of present conditions extremely difficult. In light of this, expect the recession speculation to continue, since we won’t know the “official” verdict from the NBER for well over a year.  

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