About the coming recession

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by Fabius Maximus

Summary: This month’s sharp drop in stock prices has raised fears about the US economy. Are they warranted? Is the expansion “old”? How can we predict the next recession? See the answers you won’t find in the news.

The US and global stock markets have fallen, with the usual hysterical headlines (it is up 6.1% before dividends over 12 months, up 0.6% YTD, down 7.3% from the October 3 peak). Are equity investors telling up something about the economy? The answer might shake America – businesses, households, and Washington DC.

This expansion has run for 112 months counting from the 2009 trough (the second longest), and 130 months from 2007 peak (the longest) – using the NBER’s data since 1854. It continues to run strong. When will the growth end? What happens then?

Do economic expansions grow old and die?

Glenn D. Rudebusch (Fed EVP) summarized economists’ answer in “Will the Economic Recovery Die of Old Age?” (San Francisco Fed’s Letters, 4 February 2016. He gives two graphs answer the question. First, a simple mortality table shows that people grow old and die.

Age Mortality Table

See the same graph for economic expansions. They aged and died before the Great Depression and WWII. But that 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. That is progress!

Probability of an economic expansion ending in a month

Non-economists cosplaying economists in the news often say that this expansion is “living on borrowed time.” That is false. Also, it is not a recovery. Almost all measures of economic activity long-ago passed their previous peaks. This is an economic expansion.

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 failure to follow the One True Simple Ideology of Economics. They are similar to weather: to be prepared for in advance, to be mitigated when they strike, and learned from afterwards (to do better next time).

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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.

A look at our future

First, the bad news. 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 .1%. Their forecast for 2009 was +2.8%; actual was 2.4%. The recession had begun in December 2007.

Some economists expected a recession (but being pros, 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 Recession (see my series about some claims of successful forecasts: herehere, and here).

With that out of the way, let’s look at some indicators. There are many quantitative indicators. My favorite is the Econbrowser Recession Indicator Index created by James Hamilton (econ prof at UC San Diego). The probability that Q2 was a recession was 1.1%. That’s reassuring – if you worried about that.

Econbrowser recession indicator, as of Q2 2018

Then there are the US leading indicators and the OECD’s Composite Leading Indicator (shown for the major nations and regions). They nicely show were we are; none are reliable guides to the future. All look OK today.

There are many methods for predicting recessions. None work well. Many of the best look at the shape of the yield curve. See this graph from “Predicting recessions in the United States with the yield curve” by Cyrille Lenoel (senior economist, NIESR) in the National Economic Review, May 2018. Data is as of March 2018. Backtesting shows this model’s predictions of a recession are correct 69% of the time (accuracy), but it predicts only 35% of recessions (sensitivity). The odds of recession in the next 12 months is rising fast.

Lenoel: odds of a recession using the yield curve

For more about this indicator, and what it is telling us, see this dark but clear report: “Forecasting the Next Recession: The Yield Curve Doesn’t Lie” by Guggenheim Investments, 29 October 2019 — “Our Recession Probability Model and Recession Dashboard continue to suggest a recession is likely to begin in early 2020. Investors ignore the yield curve’s signal at their peril.”

Some forecasters rely on quantitative methods and personal skill. Such as the team at the Economic Cycle Research Institute. Their co-founder, Lakshman Achuthan, gave a warning in the New York Post, October 24.

“The economy has been boosted by massive fiscal stimulus – plus an energy boom for the ages – steering it clear of recession risk. But it’s remarkable that it is already in a slowdown that not many see – certainly not the Fed.”

Their reports look at some darker aspects of recent data. They noticed that real GDP has been wonderful, but growth of real GDI (gross domestic income) has been slowing since Q2 of last year. Housing construction is weak.

There are other signs of slowing. Sales of light vehicles has been flattish since June 2014. There is another indicator “flashing red”, described by Achuthan on October 26.

“Notably, the combined debt of the US, Eurozone, Japan, and China has increased more than ten times as much as their combined GDP [growth] over the past year. …the world’s largest economies are generating debt 10X faster than economic growth. Adding debt at that pace, if it continues, will boost the debt-to-GDP ratio at an alarming rate.

“Remarkably, then, the global economy – slowing in sync despite soaring debt – finds itself in a situation reminiscent of the Red Queen Effect we referenced 15 years ago, when tax cuts boosted the US budget deficit much more than GDP. As the Red Queen says to Alice in Lewis Carroll’s Through the Looking Glass, ‘Now, here, you see, it takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!’”

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But stock prices predict recessions!

But they don’t. There is a low correlation between stock prices and GDP, or anything else (on an ex antebasis), or stock market traders would be richer than stock brokers (they’re not).  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, a stock market crash would have only a small effect on the economy. Watch the banks! If they crumble, the economy crumbles too (as it did after 1929+ and 2008-2009).

Why should we care?

We need a long warning because we are unprepared for a recession. Monetary policy is the fast and effective method to fight a recession. But with rates so low, that cannot help much. Fiscal policy is the second 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 that more difficult to use. The April 9 CBO report gave this chilling warning.

“CBO estimates that the 2018 deficit will total $804 billion, $139 billion more than the $665 billion shortfall recorded in 2017. …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 deficits during recessions — countercyclical stimulus — with surplusesduring 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 beginthe next recession with a deficit of 4 – 5%. That is insane. The politics of stimulus programs will be complex. If we have a Republican President and Congress, the US economy might have a bad time. That is guaranteed if Trump is President.

What might happen in a recession?

I wrote several posts about that during the 2015-2016 slowing, when the theory about a “stall speed” of the US economy (below which it would fall into recession) made a recession appear likely. This proved that there is no stall speed. The most valid is that the big victim of the coming stock market crash will be the San Francisco Bay Area. It sells dreams 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. Much depends on the nature of the downturn and the government’s response. The 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.



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