When Will the Recovery Begin?
Since 1854, the country has been through thirty-two business cycles. Periods of expansion have averaged about five years, and periods of recession about one and a half years. Moreover, since the 1930s, recessions have been relatively short, averaging less than twelve months.
Since it takes some time to say for sure that we are in recession, by the time we know we are in recession, we are already most of the way through it. This time, it took eight months--from March until November 2001--to determine we were in a recession. Here we are, in December 2001, and there are some signs that we may soon start to recover.
Overall, business cycles are marked by an index (or average) of four broad measures of economic activity: Sales, Income, Production and Employment. According to the Index of Coincident Indicators compiled by the Conference Board, shown in Figure 1, the economy started leveling off late last year. In November 2001, the committee of six economists of the National Bureau of Economic Research that "calls" the turning points of the business cycle, determined that the economy fell into recession in March 2001.
Along with its Index of Coincident Indicators, the Conference Board compiles an Index of Leading Indicators and an Index of Lagging Indicators. The leading indicators include measures of new orders for durable goods and permits for housing construction, along with financial variables such as the money supply, the stock market, and certain interest rates. The leading indicators might be interpreted as measures of business and consumer plans and expectations. As is clear in Figure 2, the Index of Leading Indicators turned down in late 2000, signaling a slowdown of the economy.
While subtle, it appears that the Index of Leading Indicators turned back up early during 2001. In might have been that, without the September 11 attacks on our country, the economy would already be in recovery, and might not have officially fallen into recession. However, with the attack, an already-weak economy was moved into recession status.
Thus far, only two month's data have been tabulated by the Conference Board following the September 11 attack, a fall, followed by an uptick. A leading indicator series consisting of a smaller number of components observed on a weekly basis is available nowadays from the Economic Cycle Research Institute. To be sure, this series is subject to a lot of variation. Nevertheless, the series seems to indicate that the economy faltered and then subsequently recovered following the September 11 attack (see Figure 3).
As I already mentioned, the Conference Board compiles an Index of Lagging Indicators. The lagging indicators include measures of the duration of unemployment, business inventories, and commercial and consumer indebtedness. The lagging indicators can be interpreted as measures of the degree to which the plans of businesses and consumers go unfulfilled.
Unemployment, for example, is the plan of someone to find a job that did not match up with the plan of someone else to hire. Inventory is the plan of someone to sell that did not match up with the plan of someone else to buy.
A market economy is, by definition, a decentralized economy. This means that all of us, in our capacities as buyers and sellers, employees and employers, borrowers and lenders, and so forth, make plans that depend, for their fulfillment, on the plans of others. Usually, these plans are coordinated, well enough, by the adjustment of prices, bringing supplies and demands across many different markets into balance. But, sometimes, there is a breakdown of this coordination process. Supplies and demands do not match up very well, at least not for a time.
Often, recessions involve false signals, such as artificially low interest rates due to expansionary monetary policy, or an abrupt change, such as the start of a war.& In such cases, businesses and consumers are often caught in the middle of their plans, and are only able to make changes at considerable cost. Thus, the lagging indicators often involve distress, such as unemployed workers, businesses stuck with unsold inventories, and borrowers dealing with burdensome debt.
What is interesting about the Conference Board Index of Lagging Indicators is that it seems very sensitive, nowadays, to the business cycle. The relatively mild recession from July 1990 to February 1991 was following by a substantial fall in the lagging indicators. This means that people were dealing with distress for some time following the start of recovery.
Perhaps you remember when President George Bush (the First) was asked, during his reelection campaign, if the economy was in recession. He answered that the economists were not sure. That may have been the scientifically correct answer, but it was not the politically correct answer. He should have replied, "It doesn't matter what the economists say. People are hurting."
The same thing can be said today. We may be seeing the first signs of recovery, but the distress associated with the recession will probably continue to get worse for some time.
A number of commentators are focused on the issue of "confidence," especially consumer confidence. They seem to think that we can borrow and spend our way out of this recession. To be sure, the Conference Board includes a measure of consumer confidence in its Index of Leading Indicators. While consumer confidence leads the coincident indicators, it seems to follow, rather than coincide, with recent news about the economy.
In Figure 5, I have juxtaposed an index of consumer confidence (constructed from several answers to a monthly survey of consumers conducted by the Conference Board) against an index of business confidence (constructed from several answers to a monthly survey of purchasing managers). Both series started to fall prior to the recession that began in March 2001. However, it is clear that business confidence started to fall first.
It is also clear that business confidence started to pick up, as it should have, along with the aborted recovery of the economy prior to the September 11 attacks. Consumer confidence merely stopped falling. Both business and consumer confidence fell precipitously upon the September 11 attacks; however, business confidence rebounded in the subsequent monthly survey, while consumer confidence continued to fall a little.
The greater timeliness of business confidence than of consumer confidence should not be surprising. Businessmen, and purchasing managers in particular, are naturally more focused on the economy, whereas most consumers merely filter what is already in the news and what developments they may be aware among themselves and their family and friends.
The cause of the recession, however, was not consumer spending, as the American consumer had been spending like a sailor on shore leave (until the September 11 attack). The problem was, to quote Alan Greenspan, "irrational exuberance" in the stock market. The problem manifested itself in at least two ways: a dollar that was so strong in the foreign exchange markets as to cause American producers--including farmers and manufacturers--to lose competitiveness, and the "debt-capitalization" of certain corporations at artificially high valuations, putting them at the risk of bankruptcy upon a stock market correction.
The Cause of the Recession of 2001
In addition to turning our attention to recovery, the official designation of the recession allows us to argue over what caused it. In this case, the cause is pretty obvious. At least, it's pretty clear to me.
In Figure 6, I have graphed the accumulated returns on the Dow Jones Industrial Average, an index of thirty well-established companies spread across the major sectors of the economy (the smoother line), and the Nasdaq index, an average of the thousands of companies, including many in the "infotech" sector, that trade in the Nasdaq market (the spiked line). (I constructed the chart in Yahoo.) It's pretty obvious, looking back, that going into 1999, a speculative bubble got under way; and that then, during 2000, the bubble burst.
During times of speculative bubbles, stock prices are driven by the "greater fool" theory. Normally, investors are guided by the rule of "buy low, sell high," meaning buy securities that are underpriced relative to their underlying value, and sell those that are overpriced. This rule keeps stock prices about their underlying values. But during speculative bubbles, investors are guided by the rule "buy high, sell higher," on the theory that there is a "greater fool."
In early 2000, sensing that the air was getting thin, I moved about half of my portfolio out of equities and into money market securities. I knew I was going to regret that decision. If the stock market went down, which it did, I'd regret moving only half of my portfolio. If, contrariwise, the stock market went up, I'd regret moving the half that I did. Either way, I was going to kick myself.
On the other hand, if I had just kept my money in the stock market during the past five years, ignoring the ups and downs, Figure 6 shows that I would have made a return of 45 percent (this does not include the dividends I would have received). For most investors, the best advice is indeed to ignore the ups and downs of the market, and simply invest for the long term.
Speculative bubbles pose certain problems for the economy. During the past few years, in large part because of our strong stock market, the U.S. dollar has gotten very strong in the foreign exchange market. In the long run, the exchange rate of any currency will tend to reflect its purchasing power. That is, in the long run, the goods and services that you can buy with $100 here in the United States will approximately equal what you would be able to buy, for example, in England, having exchanged the American money for British pounds. But, this is only a long-run tendency. From time to time, currencies deviate from purchasing power.
During the last few years, as during the years from about 1981 to about 1985, the dollar has gotten very strong in the foreign exchange markets of the world, much more than purchasing power would dictate. The main reason has been the strength of the U.S. securities markets. Investors all around the world see U.S. securities as both among the most secure and the highest yielding. But, in order to "buy-into" the American securities markets, they first have to buy dollars. The "raging bull" stock market of the past few years, just like the bull market associated with Ronald Reagan's first term, has resulted in a strong demand for the dollar, and a dollar that is overpriced in terms of other currencies.
The overly strong dollar has been bad news for the many American farmers and manufacturers. Farmers involved in commodity crops such as grains, and the apple-growers of this part of Virginia, have lost competitiveness in world markets. This applies both to exports and to competing against imported farm products.
In 1985, following a meeting at the Plaza Hotel in New York, the finance ministers and central bankers of the major economic nations of the world announced that they considered the dollar to be overpriced. The dollar quickly fell to a level more consistent with purchasing power. During the past few years, a series of financial crises in the world may have impeded similar action. And now, we are focused on the Afghanistan war. Nevertheless, it would be good if a similar corrective could be arranged.
A second and somewhat more complicated way that the stock market bubble of the past few years has disrupted our economy is that a number of companies recapitalized themselves at the peak of the market. They assumed debt obligations that looked reasonable at the time, but which have proven burdensome following the stock market correction. In theory, this problem could be quickly resolved by a ruthless application of the priority of claim of the security-holders involved, with minimum impact on the economy. However, our legal system allows a lot of room for debtors-in-default to forestall judgment, during which time, the workers and assets of their firms are at risk.
There's good news in admitting we are in a recession. Instead of asking questions such as "are we in" or "when will we fall in recession?" we can now turn our attention to "when will we be in recovery?"
Clifford F. Thies is a professor of economics and finance at Shenandoah University, in Winchester, VA. Send him MAIL. This article was adapted from a presentation to the Rotary Club of Clarke County, on December 12, 2001.