Mises Daily Articles
Have We Outgrown Recessions?
The economy has been in an expansionary phase for the past sixty months. According to the accepted rules of thumb, recessions are at least two quarters of negative growth in real gross domestic product (GDP). Recessions are also seen as something associated with the strength of the economy. The stronger an economy is, the less likely it is to fall into recession.
The major cause of recessions is usually seen as shocks, such as a sharp increase in the price of oil or some disruptive political events, or natural disasters or a sudden fall in consumer outlays on goods and services. If an economy is strong enough to cope with these shocks then recessions can be prevented, or at least be made less painful.
An emerging group of economists are of the view that recessions (i.e., negative growth in real GDP for at least two quarters) might be a thing of the past. They believe that strong productivity growth, a healthy global economy, and companies' successful inventory management are factors that could prevent the emergence of recessions.
Instead of having painful recessions, modern economies could be subject to mild softening in the rate of economic expansion, or so it is believed. According to this view, at the beginning of an expansionary phase the economy grows at a healthy pace. Somewhere around the midpoint, there is a slowdown and a "soft landing," i.e., the economy avoids a recession. After a short pause the economy then picks up speed again. It is held that the pause gives the economy the opportunity to recharge its batteries and re-accelerate again.
If this new theory correctly depicts the real world we live in, the current softening in the expansion could be the midpoint of the economic expansion that began five years ago. This means that after a mild decline in the rate of growth, which may last for a brief time, the economy is poised to commence the second phase of its expansion, which may last for at least another sixty months. Many experts assign high likelihood to this scenario given the fact that the previous expansion lasted from March 1991 to March 2001 — 120 months.
To be sure some economists are skeptical that the economy can remain in an expansionary phase for another five years. They believe that there is no way that consumers can continue to push the economy ahead while their level of debt is at a record high. Some other experts are of the view that the massive deficit on the current account of the balance of payments is likely to put an end to the current economic expansion.
Now, despite the disagreement on the prospects for economic growth, most experts agree that if somehow the economy could be made resilient to the various above-mentioned negatives, then recessions could be averted.
Are recessions about the strength of the economy?
According to the National Bureau of Economic Research (NBER), the institution that dates the peaks and troughs of the business cycles,
A recession is 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. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.
In the view of the NBER dating committee, because a recession influences the economy broadly and is not confined to one sector, it makes sense to pay attention to a single best measure of aggregate economic activity, which is real GDP. The NBER dating committee views real GDP as the single best measure of aggregate economic activity.
We suspect that on the back of the NBER's much more general definition, the financial press as a shortcut introduced the popular definition of a recession as two consecutive quarters of a decline in real GDP. Also, by following the two-quarters-decline-in-real-GDP rule, economists don't need to wait for the final verdict of the NBER, which often can take many months after the recession has occurred.
Regardless of whether one adopts the broader definition of the NBER or the abbreviated version, these definitions are actually failing to do the job.
After all, the purpose of a definition is to establish the essence of the object of the investigation. Both the NBER and the popular definition do not provide an explanation of what a recession is all about. Instead they describe the various manifestations of a recession.
And this is precisely what is wrong with all this. By stating that a recession is about a decline in real GDP for several or more months, one only describes and does not explain what a recession is all about. Obviously things are declining during a recession. What one wants to know is why these things are in decline. To explain a phenomenon, one needs to trace the primary causes that gave rise to it.
For instance, the essence of human action is that it is about purposeful conduct. One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful. Or we can say that all these activities are driven by the purposeful conduct of individuals.
Another grave problem with both the abbreviated and the NBER definitions is that recession is defined in terms of real gross domestic product (GDP), which supposedly mirrors the total of final real goods and services produced.
To calculate a total, several things must be added together. To add things together, they must have some unit in common. However, it is not possible to add refrigerators to cars and shirts to obtain the total of final goods. Since total real output cannot be defined in a meaningful way, obviously it cannot be quantified. To overcome this problem economists employ total monetary expenditure on goods, which they divide by an average price of those goods. But is the calculation of an average price possible?
Suppose two transactions are conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, $1000/1TV set cannot be added to $40/1shirt, implying that it is not possible to establish an average price.
On this Rothbard wrote,
Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate.
Since GDP is expressed in dollar terms, which are deflated by a dubious price deflator, it is obvious that its fluctuations will be driven by the fluctuations in the amount of dollars pumped into the economy. Hence various statements by government statisticians regarding the rate of growth of the real economy are nothing more than a reflection of the fluctuations in the rate of growth of the money supply.
Now, once a recession is assessed in terms of real GDP it is not surprising that the central bank appears to be able to counter the recessionary effects that emerge. For instance, by pushing more money into the economy the central bank's actions would appear to be effective since real GDP will show a positive response to this pumping after a short time lag. (Remember that changes in real GDP reflect changes in money supply). Observe that once the economy is expressed through GDP the central bank would appear to be able to navigate the economy (i.e., GDP) by means of a suitable policy mix.
Even if one were to accept that real GDP is not a fiction and depicts the so-called real economy there is still a problem as to why recessions are of a recurrent nature. Does it make sense that various shocks cause this repetitive occurrence of recessions? Surely there must be a mechanism here that gives rise to this repetitive occurrence?
In a free, unhampered market, we could envisage that the economy would be subject to various shocks but it is difficult to envisage a phenomenon of recurrent boom-bust cycles.
According to Rothbard,
Before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subjects; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions.
In short, the boom-bust cycle phenomenon is somehow linked to the modern world. But what is the link? Careful examination would reveal that the link is in fact the modern banking system, which is coordinated by the central bank.
The source of recessions turns out to be the alleged "protector" of the economy — the central bank itself. Further investigation would show that the phenomenon of recessions is not about the weakness of the economy as such but about the liquidation of various activities that sprang up on the back of the loose monetary policies of the central bank. Here is why.
A loose central bank monetary policy sets in motion an exchange of nothing for something, which amounts to a diversion of real wealth from wealth-generating activities to non-wealth-generating activities. In the process, this diversion weakens wealth generators, and this in turn weakens their ability to grow the overall pool of real wealth.
The expansion in the activities that came about based on loose monetary policy is what an economic "boom" (or false economic prosperity) is all about. Note that once the central bank's pace of monetary expansion has strengthened, irrespective of how strong and big a particular economy is, the pace of the diversion of real wealth is going to strengthen.
However, once the central bank tightens its monetary stance, this slows down the diversion of real wealth from wealth producers to non-wealth producers. Note that because of a time lag previous loose monetary policy tends to lift price inflation at the time when the present tighter stance is set in motion. This means that the artificial forms of life are now confronted with a decline in the rate of monetary pumping and a rise in price inflation, which amounts to the erosion in their purchasing power.
Activities that sprang up on the back of the previous loose monetary policy are now getting less support from the money supply; they fall into trouble — an economic bust, or recession emerges.
Irrespective of how big and strong an economy is, a tighter monetary stance is going to undermine various uneconomic activities that sprang up on the back of the previous loose monetary policy. This means that recessions or economic busts have nothing to do with the so-called strength of an economy, improved productivity, or better inventory management by companies.
For instance, as a result of a loose monetary stance on the part of the Fed various activities emerge to accommodate the demand for goods and services of the first receivers of newly injected money. Now, even if these activities are well managed and maintain very efficient inventory control, this fact cannot be of much help once the central bank reverses its loose monetary stance. Again, these activities are the product of the loose monetary stance of the central bank. Once the stance is reversed, regardless of efficient inventory management, these activities will come under pressure and run the risk of being liquidated. From what was said we can conclude that recessions are the liquidation of economic activities that came into being solely because of the loose monetary policy of the central bank. This whole recessionary process is set in motion when the central banks reverses its earlier loose stance.
We have established that recessions are about the liquidations of unproductive activities, but why they are recurrent? The reason for this is the central bank's ongoing policies that are aimed at fixing the unintended consequences that arise from its earlier attempts at stabilizing the so-called economy, i.e., real GDP.
On account of the time lags from changes in money to changes in prices and changes in real GDP, the central bank is forced to respond to the effects of its own previous monetary policies. These responses to the effects of past policies give rise to the fluctuations in the rate of growth of the money supply and in turn to recurrent boom-bust cycles.
We can thus cast doubt on the recent emerging view that recessions are unlikely to occur for a long period of time. As long as the central bank continues to meddle with the economy, this cannot be the case. In short, there can be no such a thing as recession-proof economy as long as the central bank continues to tamper with the economy.
How should one date peaks and troughs in economic activity?
We have seen that an important indicator for the NBER and most economists in establishing the state of the economy is real GDP. Thus a fall in real GDP for two or more quarters is classified as a likely recession. We suggest that such classification can lead to serious errors. Consider a situation where the central bank has introduced a visible tightening in its monetary stance. Consequently, the growth momentum of money supply starts to a follow a visible downtrend.
In other words, the pace of liquidation of various false activities intensifies. Now on account of various non-monetary factors, prices as measured by the GDP price deflator are gently trending down. As a result, real GDP only shows mild softening in the rate of growth, and no economist suspects that a serious recession is already at work.
Consequently, once recession erupts it takes most economists by surprise because they assess the state of the economy in terms of the strength of lagging real GDP rather than in terms of the fact that the money growth momentum has been declining.
Once it is observed that the central bank has adopted a tighter monetary stance and consequently the yearly rate of growth of money supply starts to decelerate, we can view this as the beginning of the liquidation phase, or the beginning of a recession. As long as the downtrend in the growth momentum of money stays in force, the liquidation phase also stays intact.
Once the trend is reversed — i.e., once the central bank reverses its tight stance and consequently the growth momentum of money starts to rise — this can be seen as the end of a recession. In short, the end of a recession is here the beginning of the build-up of new artificial forms of life or the strengthening of the older, still surviving, artificial forms of life.
According to the NBER since 1854 the longest expansion was between March 1991 to March 2001 — ten years or 120 months. Indeed if one looks at real GDP during this period, it didn't have negative growth for two consecutive quarters. Also, on a year-on-year comparison basis, real GDP during that period has displayed an ongoing positive growth.
So if one were to follow the conventional definition, one would have to accept that things were just great during that period. However, if one looks at the growth momentum of monetary measure AMS then one gets a completely different story (see chart below).
After rising to 13% in Q4 1992 the yearly rate of growth of AMS fell to 0.2% by Q2 1995. Thereafter the yearly rate of growth was in an uptrend until Q4 1998 when it closed at 6.9%. Afterwards the rate of growth was decelerating again falling to 0.9% by Q4 2000. Obviously the phase between Q4 1992 to Q2 1995 was the liquidation, or a recession phase. Likewise the phase between Q4 1998 to Q4 2000 was also a recession phase.
The Help Wanted Index, which is based on a monthly count of help-wanted advertisements appearing in the classified section of major newspapers, shows that after reaching 90 on December 1994 the index fell to 80 by May 1995 — a fall of 11.1%. The index fell by 19.4% between March 1999 and November 2000. Also, the number of housing starts fell by 18.1% between March 1994 and June 1995. Housing starts fell by 15.7% between February 2000 and July 2000.
The Transportation Services Index, which measures the movement of freight and passengers, closed at 85.2 in June 1995 versus 91.1 in December 1994 — a fall of 6.5%. This index fell by 4.1% between January 1999 and December 2000. Additionally, weekly hours worked in manufacturing fell by 1.4% between May 1994 and June 1995. The weekly hours worked in the manufacturing sector fell by 2.9% in December 2000 from July 1999. Note that all these falls took place during the supposed economic expansion.
What does the growth momentum of our monetary measure AMS currently indicate? After rising to 7.9% in Q2 2004 the yearly rate of growth of AMS has been in a downtrend. By Q3 this year, the yearly rate of growth stood at 1.2%. From this we can infer that regardless of what so-called real GDP is doing and is going to do in the quarters ahead, the liquidation phase or the recession phase has actually begun in Q2 2004. If one looks at the help wanted index after rising to 42 in January 2005, the index closed at 30 in September this year — a fall of 28.6%. Likewise after peaking at an annual 2.265 million units in January this year housing starts fell to 1.486 million units annualized in October a fall of 34.4%. The Transportation Services Index fell by 3% in August this year against May. Meanwhile, average weekly hours in the manufacturing sector fell by almost 1% in September from July.
Contrary to the accepted way of thinking, recessions are not negative growth in GDP for at least two consecutive quarters.
Recessions, which are set in motion by a tight monetary stance of the central bank, are about the liquidations of activities that sprang up on the back of the previous loose monetary policies. Rather than paying attention to the so-called strength of real GDP to ascertain where the economy is heading, it will be more helpful to pay attention to the rate of growth of the money supply.
By following the rate of growth of the money supply, one can ascertain the pace of damage to the real economy that central bank policies inflict. Thus the increase in the growth momentum of money should mean that the pace of wealth destruction is intensifying. Conversely, a fall in the growth momentum of money should mean that the pace of wealth destruction is weakening.
Additionally, once it is realized that so-called real economic growth, as depicted by real GDP, mirrors fluctuations in the money supply rate of growth, it becomes clear that an economic boom has nothing to do with real and sustainable economic expansion. On the contrary such a boom is about real economic destruction, since it undermines the pool of real funding — the heart of real economic growth.
Hence despite "good GDP" data, many more individuals may find it much harder to make ends meet.