Definition
In a 1974 The New York Times article, Commissioner of the Bureau of Labor Statistics Julius Shiskin suggested several rules of thumb for defining a recession, one of which was two consecutive quarters of negative GDP growth.[6] In time, the other rules of thumb were forgotten. Some economists prefer a definition of a 1.5-2 percentage points rise in unemployment within 12 months.[7]
In the United States, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) is generally seen as the authority for dating US recessions. The NBER, a private economic research organization, defines an economic recession as: "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".[8] Almost universally, academics, economists, policy makers, and businesses refer to the determination by the NBER for the precise dating of a recession's onset and end.
In the United Kingdom, recessions are generally defined as two consecutive quarters of negative economic growth, as measured by the seasonal adjusted quarter-on-quarter figures for real GDP.[4][5] The same definition is used by member states of the European Union.[citation needed]
Attributes
A recession has many attributes that can occur simultaneously and includes declines in component measures of economic activity (GDP) such as consumption, investment, government spending, and net export activity. These summary measures reflect underlying drivers such as employment levels and skills, household savings rates, corporate investment decisions, interest rates, demographics, and government policies.
Economist Richard C. Koo wrote that under ideal conditions, a country's economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero.[9][10] When these relationships become imbalanced, recession can develop within the country or create pressure for recession in another country. Policy responses are often designed to drive the economy back towards this ideal state of balance.
A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different.[7] As an informal shorthand, economists sometimes refer to different recession shapes, such as V-shaped, U-shaped, L-shaped and W-shaped recessions.
Type of recession or shape
High levels of indebtedness or the bursting of a real estate or financial asset price bubble can cause what is called a "balance sheet recession". This is when large numbers of consumers or corporations pay down debt (i.e., save) rather than spend or invest, which slows the economy. The term balance sheet derives from an accounting identity that holds that assets must always equal the sum of liabilities plus equity. If asset prices fall below the value of the debt incurred to purchase them, then the equity must be negative, meaning the consumer or corporation is insolvent. Economist Paul Krugman wrote in 2014 that "the best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt—that it was a so-called "balance sheet recession". In Krugman's view, such crises require debt reduction strategies combined with higher government spending to offset declines from the private sector as it pays down its debt.[15]
For example, economist Richard Koo wrote that Japan's "Great Recession" that began in 1990 was a "balance sheet recession". It was triggered by a collapse in land and stock prices, which caused Japanese firms to have negative equity, meaning their assets were worth less than their liabilities. Despite zero interest rates and expansion of the money supply to encourage borrowing, Japanese corporations in aggregate opted to pay down their debts from their own business earnings rather than borrow to invest as firms typically do. Corporate investment, a key demand component of GDP, fell enormously (22% of GDP) between 1990 and its peak decline in 2003. Japanese firms overall became net savers after 1998, as opposed to borrowers. Koo argues that it was massive fiscal stimulus (borrowing and spending by the government) that offset this decline and enabled Japan to maintain its level of GDP. In his view, this avoided a U.S. type Great Depression, in which U.S. GDP fell by 46%. He argued that monetary policy was ineffective because there was limited demand for funds while firms paid down their liabilities. In a balance sheet recession, GDP declines by the amount of debt repayment and un-borrowed individual savings, leaving government stimulus spending as the primary remedy.[9][10][16][17]
Krugman discussed the balance sheet recession concept during 2010, agreeing with Koo's situation assessment and view that sustained deficit spending when faced with a balance sheet recession would be appropriate. However, Krugman argued that monetary policy could also affect savings behavior, as inflation or credible promises of future inflation (generating negative real interest rates) would encourage less savings. In other words, people would tend to spend more rather than save if they believe inflation is on the horizon. In more technical terms, Krugman argues that the private sector savings curve is elastic even during a balance sheet recession (responsive to changes in real interest rates) disagreeing with Koo's view that it is inelastic (non-responsive to changes in real interest rates).[18][19]
A July 2012 survey of balance sheet recession research reported that consumer demand and employment are affected by household leverage levels. Both durable and non-durable goods consumption declined as households moved from low to high leverage with the decline in property values experienced during the subprime mortgage crisis. Further, reduced consumption due to higher household leverage can account for a significant decline in employment levels. Policies that help reduce mortgage debt or household leverage could therefore have stimulative effects.[20][21]
Liquidity trap
A liquidity trap is a Keynesian theory that a situation can develop in which interest rates reach near zero (zero interest-rate policy) yet do not effectively stimulate the economy. In theory, near-zero interest rates should encourage firms and consumers to borrow and spend. However, if too many individuals or corporations focus on saving or paying down debt rather than spending, lower interest rates have less effect on investment and consumption behavior; the lower interest rates are like "pushing on a string". Economist Paul Krugman described the U.S. 2009 recession and Japan's lost decade as liquidity traps. One remedy to a liquidity trap is expanding the money supply via quantitative easing or other techniques in which money is effectively printed to purchase assets, thereby creating inflationary expectations that cause savers to begin spending again. Government stimulus spending and mercantilist policies to stimulate exports and reduce imports are other techniques to stimulate demand.[22] He estimated in March 2010 that developed countries representing 70% of the world's GDP were caught in a liquidity trap.[23]
Paradoxes of thrift and deleveraging
Behavior that may be optimal for an individual (e.g., saving more during adverse economic conditions) can be detrimental if too many individuals pursue the same behavior, as ultimately one person's consumption is another person's income. Too many consumers attempting to save (or pay down debt) simultaneously is called the paradox of thrift and can cause or deepen a recession. Economist Hyman Minsky also described a "paradox of deleveraging" as financial institutions that have too much leverage (debt relative to equity) cannot all de-leverage simultaneously without significant declines in the value of their assets.[24]
During April 2009, U.S. Federal Reserve Vice Chair Janet Yellen discussed these paradoxes: "Once this massive credit crunch hit, it didn’t take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole."[24]
Predictors
The U.S. Conference Board's Present Situation Index year-over-year change turns negative by more than 15 points before a recession.[25][26][27]
The U.S. Conference Board Leading Economic Indicator year-over-year change turns negative before a recession.[28][29]
When the CFNAI Diffusion Index drops below the value of -0.35, then there is an increased probability of the beginning a recession. Usually the signal happens in the three months of the recession. The CFNAI Diffusion Index signal tends to happen about one month before a related signal by the CFNAI-MA3 (3-month moving average) drops below the -0.7 level. The CFNAI-MA3 correctly identified the 7 recessions between March 1967–August 2019, while triggering only 2 false alarms.[30]
Except for the above, there are no known completely reliable predictors, but the following are considered possible predictors.[31]
Inverted yield curve,[32] the model developed by economist Jonathan H. Wright, uses yields on 10-year and three-month Treasury securities as well as the Fed's overnight funds rate.[33] Another model developed by Federal Reserve Bank of New York economists uses only the 10-year/three-month spread.[34] It is, however, not a definite indicator;[citation needed]
The three-month change in the unemployment rate and initial jobless claims.[35] U.S. unemployment index defined as the difference between the 3-month average of the unemployment rate and the 12-month minimum of the unemployment rate.[36] Unemployment momentum and acceleration with Hidden Markov model.[37]
Index of Leading (Economic) Indicators (includes some of the above indicators).[38]
Lowering of asset prices, such as homes and financial assets, or high personal and corporate debt levels.
Commodity prices may increase before recessions, which usually hinders consumer spending by making necessities like transportation and housing costlier. This will tend to constrict spending for non-essential goods and services. Once the recession occurs, commodity prices will usually reset to a lower level.
Increased income inequality.[39][40]
Decreasing recreational vehicle shipments.[41]
Declining trucking volumes.[42][43]
Analysis by Prakash Loungani of the International Monetary Fund found that only two of the sixty recessions around the world during the 1990s had been predicted by a consensus of economists one year earlier, while there were zero consensus predictions one year earlier for the 49 recessions during 2009.[44]
Government responses
See also: Stabilization policy
Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions. Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow. Monetarists would favor the use of expansionary monetary policy, while Keynesian economists may advocate increased government spending to spark economic growth. Supply-side economists may suggest tax cuts to promote business capital investment. When interest rates reach the boundary of an interest rate of zero percent (zero interest-rate policy) conventional monetary policy can no longer be used and government must use other measures to stimulate recovery. Keynesians argue that fiscal policy—tax cuts or increased government spending—works when monetary policy fails. Spending is more effective because of its larger multiplier but tax cuts take effect faster.
For example, Paul Krugman wrote in December 2010 that significant, sustained government spending was necessary because indebted households were paying down debts and unable to carry the U.S. economy as they had previously: "The root of our current troubles lies in the debt American families ran up during the Bush-era housing bubble...highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years. This would be fine if someone else were taking up the slack. But what’s actually happening is that some people are spending much less while nobody is spending more — and this translates into a depressed economy and high unemployment. What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down. And this government spending needs to be sustained..."[45]
Stock market
Some recessions have been anticipated by the stock market declines. In Stocks for the Long Run, Siegel mentions that since 1948, ten recessions were preceded by a stock market decline, by a lead time of 0 to 13 months (average 5.7 months), while ten stock market declines of greater than 10% in the Dow Jones Industrial Average were not followed by a recession.[46]
The real-estate market also usually weakens before a recession.[47] However real-estate declines can last much longer than recessions.[48]
Since the business cycle is very hard to predict, Siegel argues that it is not possible to take advantage of economic cycles for timing investments. Even the National Bureau of Economic Research (NBER) takes a few months to determine if a peak or trough has occurred in the US.[49]
During an economic decline, high yield stocks such as fast-moving consumer goods, pharmaceuticals, and tobacco tend to hold up better.[50] However, when the economy starts to recover and the bottom of the market has passed, growth stocks tend to recover faster. There is significant disagreement about how health care and utilities tend to recover.[51] Diversifying one's portfolio into international stocks may provide some safety; however, economies that are closely correlated with that of the U.S. may also be affected by a recession in the U.S.[52]
There is a view termed the halfway rule[53] according to which investors start discounting an economic recovery about halfway through a recession. In the 16 U.S. recessions since 1919, the average length has been 13 months, although the recent recessions have been shorter. Thus, if the 2008 recession had followed the average, the downturn in the stock market would have bottomed around November 2008. The actual US stock market bottom of the 2008 recession was in March 2009.
Politics
Generally an administration gets credit or blame for the state of economy during its time.[54] This has caused disagreements about on how it actually started.[55] In an economic cycle, a downturn can be considered a consequence of an expansion reaching an unsustainable state, and is corrected by a brief decline. Thus it is not easy to isolate the causes of specific phases of the cycle.
The 1981 recession is thought to have been caused by the tight-money policy adopted by Paul Volcker, chairman of the Federal Reserve Board, before Ronald Reagan took office. Reagan supported that policy. Economist Walter Heller, chairman of the Council of Economic Advisers in the 1960s, said that "I call it a Reagan-Volcker-Carter recession."[56] The resulting taming of inflation did, however, set the stage for a robust growth period during Reagan's presidency.[citation needed].
Economists usually teach that to some degree recession is unavoidable, and its causes are not well understood. Consequently, modern government administrations attempt to take steps, also not agreed upon, to soften a recession.
Consequences
Unemployment
Unemployment is particularly high during a recession. Many economists working within the neoclassical paradigm argue that there is a natural rate of unemployment which, when subtracted from the actual rate of unemployment, can be used to calculate the negative GDP gap during a recession. In other words, unemployment never reaches 0 percent, and thus is not a negative indicator of the health of an economy unless above the "natural rate," in which case it corresponds directly to a loss in the gross domestic product, or GDP.[57]
The full impact of a recession on employment may not be felt for several quarters. Research in Britain shows that low-skilled, low-educated workers and the young are most vulnerable to unemployment[58] in a downturn. After recessions in Britain in the 1980s and 1990s, it took five years for unemployment to fall back to its original levels.[59] Many companies often expect employment discrimination claims to rise during a recession.[60]
Business
Productivity tends to fall in the early stages of a recession, then rises again as weaker firms close. The variation in profitability between firms rises sharply. The fall in productivity could also be attributed to several macro-economic factors, such as the loss in productivity observed across UK due to Brexit, which may create a mini-recession in the region. Global epidemics, such as CoViD-19, could be another example, since they disrupt the global supply chain or prevent movement of goods, services and people.
Recessions have also provided opportunities for anti-competitive mergers, with a negative impact on the wider economy: the suspension of competition policy in the United States in the 1930s may have extended the Great Depression.[59]
Social effects
The living standards of people dependent on wages and salaries are not more affected by recessions than those who rely on fixed incomes or welfare benefits. The loss of a job is known to have a negative impact on the stability of families, and individuals' health and well-being. Fixed income benefits receive small cuts which make it tougher to survive
