When Will the U.S. Economy Recover?
Recent releases of key economic indicators paint a gloomy economic picture. Year-on-year industrial production fell by 5.8 percent in September, after a fall of 4.6 percent in the previous month. This is the twelfth consecutive decline. The yearly rate of growth in retail sales fell to 0.2 percent in September from 3.7 percent in August. Furthermore, non-farm employment was down by almost 200,000 in September. The GDP’s rate of growth fell to an annual 0.3 percent in Q2, from 1.3 percent in the previous quarter.
Economists are unsure whether this weakening in economic data points to a recession in the months ahead. Chief White House economic aide Lawrence Lindsey believes that U.S. aggregate demand, as depicted by real GDP, is likely to contract for two straight quarters—which would meet the popular definition of a recession. In contrast, Federal Reserve Bank of St. Louis President William Poole does not expect GDP to display negative growth for two consecutive quarters. He says that a recession is not a done deal.
Is there any merit to the popular definition of recession? Why must it be two quarters of negative growth and not one, or perhaps three? It is true that, during a recession, one observes declines in general demand for goods and services. This does not mean, however, that recessions are caused by falling demand. There are some other negative factors that one might observe, e.g., growing crime and rising unemployment. Surely such factors are also important causes of a recession. Why the focus on GDP?
The purpose of any definition in macroeconomics is to identify the key driving elements of the phenomenon we are trying to identify. The definition of a recession should at least identify a recession’s fundamental driving factors. This is precisely what the popular definition fails to do. It regards declines in aggregate demand as the driving force of a recession. Aggregate demand, however, doesn’t have a life of its own; it can be only exercised as a result of preceding production.
It is through the production of goods and services that every individual can exercise demand for goods and services produced by others. The more that is produced, the greater the purchasing power of every individual becomes, and, therefore, the greater the demand that can be exercised. From this we can infer that the causes of recessions are most likely to be found on the production side rather than with general demand.
The distinguishing characteristic of a successful producer is his ability to "read the market correctly," thereby establishing a profitable production structure. It is in the interest of every businessman to secure a price where the quantity of goods that is produced can be sold at a profit. In setting this price, a producer/entrepreneur will have to consider how much money consumers are likely to spend on the product. He will have to consider the prices of various competitive products. He will also have to consider his production costs.
A producer must also pay attention to likely movements in interest rates. By complying with market prices and interest rates, the producer is said to be "in tune" with reality. Whenever he misjudges future prices and interest rates, he is said to be "out of sync" with market conditions, and he suffers losses.
A major factor that distorts producers’ judgments regarding the true conditions of the market is the central bank’s easy monetary policy. This policy leads to an artificial lowering of interest rates, thereby falsifying an important market signpost that producers pay attention to. Consequently, this triggers activities that are out of touch with reality—an economic "boom" is set in motion.
The central bank’s easy monetary policy causes producers to make business errors. Once the central bank tightens its monetary stance, however, the facts of reality are revealed, various activities that sprang up on the back of previous loose monetary policies are abandoned, and an economic bust emerges. From this we can infer that a recession is: a process whereby business errors brought about by past easy monetary policies are revealed and liquidated once the central bank tightens its monetary stance.
This definition of a recession--a business-error liquidation process--informs us that the driving force of boom-bust cycles is central bank monetary policies. By paying attention to the central bank’s policies, one can get a clue regarding where the economy is in the boom-bust cycle.
Contrast this with the popular definition, which only describes symptoms of a recession and tells us absolutely nothing about its driving forces. To say that recessions are about declining general demand is merely describing and not explaining what recessions are.
When pressed, mainstream economists attribute declines in general demand to various mysterious shocks, or changes in people’s psychology. In other words, people suddenly go berserk and lose their will to better their lives and well-being. But even if one can find that there are some individuals who behave this way, is it really conceivable that an entire population could be subject to such odd behavior over a prolonged period of time?
Likewise, shocks have nothing to do with recessions. Shocks can cause disruptions. However, they do not set in motion a mechanism that persistently falsifies interest rates and thereby causes producers to misjudge true market conditions.
Recessions, then, are not really about two consecutive quarters of a negative growth in real GDP. They are not about shocks or loss of confidence. They are about the liquidations of business errors brought about by previous loose monetary policies. The ensuing adjustment of production may, or may not, manifest itself through the negative GDP rate of growth.
According to Mises, "It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by entrepreneurs."
This definition of a recession embraces not only "ordinary" recessions but also depressions. The only difference between a recession and a depression is the extent of business errors. In other words, the longer the boom, the more severe the bust is going to be. Furthermore, the severity of the slump is affected by the state of the real pool of funding. A growing pool of funding—savings and capital stored up to make future production possible—will make the business error adjustment process easy to handle. Conversely, a stagnant or a declining pool will make the adjustment process more painful.
The Current State of the U.S. Economy
Whenever the central bank changes interest rates, the impact of this change on producers is not instantaneous. It takes time before the effect of a change starts to assert itself. Historically, the average time lag between changes in the federal funds rate and changes in the yearly rate of growth of industrial production has been twelve months.
Using this historical time lag, we can suggest that, in response to the tighter interest rate stance between June 1999 and May 2000, the current recession—or the current cyclical downturn—began in June last year. In other words, by raising the federal funds rate from 5 percent in June 1999 to 6.5 percent in May 2000, the Fed had set in motion in June 2000 the correction of past business errors.
Since January, the Fed has embarked on the new stage of lowering interest rates. The central bank has lowered the federal funds rate from 6 percent to 2.5 percent, i.e., 350 basis point so far this year. This artificial lowering, after a time lag of twelve months, is likely to set in motion a renewed misallocation of resources, which will manifest itself early next year through a cyclical upturn.
As such, a cyclical upturn doesn’t cause real economic growth. It only misdirects the given pool of real savings, or real funding, thereby weakening potential economic growth. As long as the real pool of funding is growing, an aggressive loose monetary policy can "stage a strong cyclical upturn"—i.e., strong positive year-on-year percentage rises in economic activity. If, however, the real pool of funding is stagnating—or, worse, declining—the cyclical rebound will be associated with a subdued rate of growth in real economic activity.
A major negative for the real pool of funding is rises in money supply. These rises set in motion an exchange of nothing for something, which weakens the flow of real savings and thereby undermines the real pool of funding. Since 1980, the U.S. has experienced large monetary injections. A major cause responsible for this is the "liberalization" of financial markets, which removed various restrictions on banks lending "out of thin air." The magnitude of money creation since 1980 is presented on the chart below.
Observe that in September of this year, money AMS was 62 percent above the trend, which is based on the history between 1959 and 1979. This massive increase in the money stock has been associated with a corresponding collapse in personal savings (see chart). In short, every dollar that was created "out of thin air" amounts to a corresponding dis-saving by that same amount.
This large money creation has also been accompanied by the relentless lowering of federal funds rates, which stood at 19.1 percent in June 1981.
This prolonged artificial lowering of interest rates must have contributed to a large overinvestment in capital-goods versus consumer-goods production, thereby hurting the pool of funding (see chart).
From what has been said so far, it will come as no surprise that the real pool of funding is in bad shape, implying that the cyclical upturn early next year could barely be felt in terms of general economic activity.
Implications for Stock Markets
As a result of the Fed’s aggressive loose monetary policy, the yearly rate of growth of money AMS adjusted for nominal economic activity jumped to 11 percent in September, from 8.6 percent in August and –5.3 percent in January (see chart).
However, this strong liquidity buildup without the backup from company profits will not be able to generate a sustainable stock market recovery. Moreover, the present record-high P-E ratio (see chart) doesn’t bode well for stocks. Unless the real pool of funding is still in good shape, the prospects for a healthy turnaround in corporate profits do not appear to be very promising.
Obviously, if the pool of funding is on solid footing, we should witness a strong economic rebound and a strong rebound in stocks. However, a possible negative that might mitigate the rebound in stocks in this scenario is the likely acceleration in price inflation as a result of the Fed’s loose monetary policy.
The large overinvestment in capital-goods versus consumer-goods production means that, on a relative basis, greater profit opportunities will be found in companies that to a large extent are engaged in the production of final consumer goods. The stocks of companies that are associated with activities that are directly or indirectly linked to capital-goods production are expected to underperform. Furthermore, within the framework of a stagnant pool of funding on account of rising bad debts, bank stocks are likely to come under pressure.
Implications for Interest Rates
Within the framework of a "shaky" pool of funding and an invisible cyclical upturn, it is likely that the Fed will lower interest rates further. As a result, the differential between the yield on the ten-year T-bond and the federal funds rate, which stood at 1.6 percent at the end of September, is likely to widen further.
The strong buildup in liquidity, coupled with subdued economic activity, is likely to benefit the Treasury bond market (see chart). If the pool of funding is "doing OK," however, then a possible rebound in price inflation might mitigate the effect of the buildup in liquidity.
Summary and Conclusions
If public opinion holds that a recession is caused by declines in GDP, it makes sense for the central bank to prop up economic activity to prevent its occurrence. The reality, however, is that the essence of a recession is the liquidation of business errors caused by loose monetary policies of the central bank.
Using this definition of recession, the U.S. economy has been in the downward phase of the economic cycle (recession) since June 2000. Based on the historical data, there is a high likelihood of a cyclical rebound early next year. This rebound, however, is not likely to have much of an impact because the foundations of a strong recovery do not currently exist.
Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Archive. Shostak will be speaking at a Private Retreat with Austrian Economists, January 18-19, 2002.
 Ludwig von Mises, Human Action (Chicago: Contemporary Books,1963), p. 505.