A look at the US economy, and the next recession

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by Fabius Maximus 

Summary: Trump’s mad efforts to start trade wars puts the US economy under stress. The outcome of the 2020 elections depends on the performance of the US economy in the next 17 months. How strong Is the US economy? Is the expansion “old”? Can we predict the next recession, and take fast action to mitigate it? This is an update and revision of my October 2018 post.

Two people before a graph warning of a recession.
ID 125081618 © Iurii Golub | Dreamstime.

This expansion has run for 120 months from the 2009 trough, a tie for the longest expansion with 1991 – 2001 (see the NBER’s data since 1854. The Fed’s GDPnow algorithm estimates Q2 GDP at a still-healthy 2.0% SAAR. All expansions end in recessions. When will that happen, assuming Trump does not start one?

Indicators show our future

Professional economic forecasters see steady growth for the next 12 months. Unfortunately, economists have little ability to predict recessions. Surveys of economists’ consensus forecast have never successfully predicted a recession.  For example, look at the predictions made in February 2008. The consensus forecast for real GDP in 2008 was +1.8%; actual was 0.1%. Their forecast for 2009 was +2.8%; actual was 2.4%. The recession had begun in December 2007.

Some economists predicted that a recession was likely after 2005, but being pros, they were vague about when. I have found nobody that predicted the collapse of the global banking system, which turned a US real estate downturn into the Great Global Recession (see my series about some claims of successful forecasts: herehere, and here).

Let’s look at some methods used to predict recessions. None work well. I prefer the quantitative indicators, with little human input. My favorite is the Econbrowser Recession Indicator Indexcreated by James Hamilton (econ prof at UC San Diego). The probability that Q2 was a recession was 2.4%. Not terrifying.

GDP-based recession indicator


There are other quantitative indicators, such as the index of US leading indicators: flattish since November 2010. There is also the OECD’s Composite Leading Indicator (an interactive display; select the nations and regions): slowing, below average, at the low end of the non-recession range. The Economic Cycle Research Institute’s Weekly Leading Index looks strong. These indicators show where we are; none are reliable guides to the future.

Other indicators look at the shape of the yield curve. See this graph from the Cleveland Fed, predicting 2% real GDP growth for the next 12 months. The yield curve has been among the most reliable economic indicators, but some economists believe it is no longer reliable.

These predictive tools show low odds of a recession in the immediate future.

Let’s get more granular!

What about the specific measures of economic activity that flood the business page. They excite journalists because their volatility generates easy headlines. Good news, bad news, the end is nigh!But most look ok, although there are signs of weakness. Auto sales remain strongHousing starts remain stableInventories are high but stable. My favorite is the Cass North American Transportation freight volume index. As of May, volume is down year-over-year, but still up from 2017 (see the full report). It is one of the warning signs amidst the mostly good news.

Cass Freight Index - Shipments - May 2019

Stock prices predict recessions!

No, they don’t. There is a low correlation between stock prices and GDP, or anything else (on an ex ante basis). Investors in stock and bonds have no special insights, either as individuals or crowds. My favorite example was their inability to see WWI as it began. On the other hand, there are some indicators that the US stock market is grossly overvalued. It might be on the verge of a bear market, or even a crash.

Goldman Sachs Bear Market Risk Indicator

The good news is that a stock market crash would have only a small effect on the economy. The banks are much more important than the stock market. If they crumble, as they did after 1929 and 2008, then the economy crumbles too.

Has this economic expansions grown old? Will it die?

Although the numbers look fine so far, is a recession likely soon because the expansion is so old? Non-economists cosplaying economists in the news often say that this expansion is “living on borrowed time.” Glenn D. Rudebusch (Fed EVP) summarizes economists’ answer in “Will the Economic Recovery Die of Old Age?” in the San Francisco Fed’s Letters, 4 February 2016. He gives two graphs to answer this question. First, a simple mortality table shows that people grow old and die.

Age Mortality Table

See the same graph for economic expansions. Back then they aged and died. But the Great Depression and WWII taught economists about the value of economic stabilizers (e.g., unemployment insurance), plus fiscal and monetary stimulus. Since then the odds of recession ending each month increase only slightly over time. Expansions age only slowly and slightly. That is progress!

Probability of an economic expansion ending in a month

Trivia note: we are not in an economic “recovery.” Almost all measures of economic activity long-ago passed their previous peaks. This is an “expansion.”

AP Photo/Mark Lennihan

Why should we care?

We must stay vigilant, watching the economy. Policy responses are slow to take effect, so we need as much warning as we can get. Worse, today we are unprepared for a downturn. Monetary policy is the fastest tool to fight a recession. But with rates so low, interest rates cuts cannot do much. Fiscal policy is the other big tool. Trump’s tax cuts, part of the GOP’s long-term effort to make the rich richer – and bleed the Federal government – will make large-scale fiscal more difficult. An April 2018 CBO report gave this chilling warning about Trump’s large and rising deficits – unprecedented during an economic expansion.

“In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2% of GDP this year to 5.1% in 2022 (adjusted to exclude the shifts in timing). That percentage has been exceeded in only five years since 1946; four of those years followed the deep 2007–2009 recession.”

Keynes recommended running fiscal deficits during recessions – as a countercyclical stimulus – and surpluses during expansions. The GOP keeps cutting taxes during expansions, sending the Federal deficit skyrocketing. Reagan did it. Bush Jr. did it. Now Trump has done it. The Federal deficit was 1.1% of GDP in 2007. It zoomed during the recession as tax receipts crashed and expenditures rose (e.g., unemployment and welfare payments, and later the fiscal stimulus).

We will begin the next recession with a deficit of 4 – 5%. That is insane. The politics of stimulus programs will be complex, and might prove disastrous during the next recession.

Melancholy by Edvard Munch (1894)
Painting by Edvard Munch (1894).

What might happen in the next recession?

The worst affected area in the coming stock market crash will be the San Francisco Bay Area. Its biggest industry is selling dreams (e.g., stock certificates in unprofitable companies) for money, an industry that I expect to crash hard in the next recession. The accelerating exodus of middle-class families makes the region even more vulnerable.

Beyond that, we can only guess at the dynamics of the next recession. Much depends on the nature of the downturn and the government’s response. Many private and public pension systems are already weak, despite the long expansion. A stock market crash and long recession will push many past the point of recovery, as the date at which their cash flows turn negative approaches (i.e., more payments than contributions). See this about the coming bankruptcy of government pension plans. Also, boomers have saved too little for retirement, and too much of that is in real estate and stocks – both probably severe casualties of a long recession.

My best guess: it won’t be pretty. My advice: expect the unexpected, and start preparing now.

What kills expansions?

People often confuse signs of a slowdown (e.g., consumer confidence falls, economic activity slows) with the factors that cause the slowdown. Such as economic or political shocks. A partial list includes trade wars, real wars, monetary policy (excessive rate increases by the Fed, restrictions on lending, breaking growth of the money supply), fiscal policy (large cuts in spending, large tax increases), and popping of big investment bubbles. As with most disasters, multiple errors are usually necessary (a dozen mistakes, plus an iceberg, sank the Titanic). There are many links that can break in our complex world.

Two causes are especially common in the post-WWII era. First, the Fed brakes too hard to prevent “overheating.” Sometimes overheating means a rapid rise of inflation. Sometimes it means full employment forcing businesses to share productivity growth with their workers. “Profit inflation” is good in bankers’ eyes. “Wage inflation” is bad!

Second, “imbalances” in the economy. These can be excessive growth in government, consumer, or business borrowing – which ends suddenly, creating a shock. Or sector imbalances – such as the tech boom and the regional real estate boom-bust cycles.

The slow growth in real GDP after the 2008-2009 bust – roughly 2.5% from 2010 – 2017 – created few imbalances. Optimists cheered as the dawn of a new age the Q2 growth of 4.2% (SAAR) and Q3’s 3.5%. Just as they did in 2014: Q2 of 5.2% and Q3 4.9%. But those micro-booms fizzled. As this one might: estimates for Q4 are about 2.7% – despite the GOP’s massive debt-fueled fiscal stimulus (quite mad to do late in an economic expansion, when we should be reducing the Federal deficit).

Recessions and depressions are normal!

“Thou know’st it’s common; all that lives must die,
Passing through nature to eternity.”
— Queen Gertrude to Hamlet (Act I, scene 2).

Something will eventually end an expansion. Expansions are part of the business cycle, along with recessions – and depressions. They do not represent God’s judgement on our moral faults, or our failure to follow the One True Simple Ideology of Economics.

The US economy has been in a recession roughly 20% of the time since 1854. Depressions were frequent before the creation of the Fed and use of fiscal stabilizers. Recessions and depressions are less frequent now, but they still happen. Like extreme weather, we have to prepare for the inevitable.




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