Greater Opportunity Through Innovative Change
CASE FOR RECESSION
By: Greg Kaza
A review of key market indicators and government data suggests a major sector of the U.S. economy has entered recession.
Recession is commonly defined as two consecutive quarters of negative Gross Domestic Product (GDP), adjusted for inflation. GDP is the total market value of all goods and services produced domestically in a period. Prior to 1991, the United States used Gross National Product (GNP), a similar concept. The National Bureau of Economic Research (NBER) determines when the U.S. economy has entered recession. The NBER uses a more complex set of data focusing on four indicators: industrial production, employment, real income and sales activity.
Americans are living through the longest recorded economic expansion in U.S. history, now in its 10th year. A number of factors have contributed to the expansion, including technological advances, entrepreneurial initiative, productivity increases, wage flexibility, disinflation and a credit structure unique by historical standards. Prior expansions have been followed by economic contractions, a natural result of the business cycle. According to the NBER, there were 20 U.S. recessions in the 20th Century. The longest, the Great Depression (1929-33), lasted nearly four years and was followed by a second decline (1937-38) that has led some economists to view the period as "a lost decade." The shortest recessions have lasted only two quarters.
The NBER is the sole body determining when the U.S. economy enters recession. Many government data are lagging indicators, subject to upward or downward revision. For example, GDP growth was initially positive in the first quarter of the past four recessions as defined by NBER. A recession starting in December would show GDP expanding in the entire fourth quarter. Although largely forgotten today, downward revisions preceded formal declaration of the last recession, marked by a furious political debate around the question of whether the U.S. economy was in contraction.
GDP fell last year from 4.8 percent in First Quarter 2000 to 1.0 percent in the Fourth Quarter.. The Federal Reserve, the U.S. central bank, sets monetary policy by establishing reserve requirements for depository institutions; buying and selling U.S. treasuries in the open market; and setting short-term interest rates, including the discount rate charged member banks. The Humphrey-Hawkins Act requires the Fed to consider inflation and unemployment in setting monetary policy. In the first five months of 2001 the Fed has increased the money supply by cutting short rates 50 basis points on five separate occasions. This unusual action is highly suggestive of the challenge facing the U.S. economy.
Inversion of the Yield Curve
"At the turn of the
century the corporate bond market occupied such a dominant position in
American finance that the student of long- and medium-term interest rates
would necessarily have devoted most, if not all, of his energies to the
measurement of corporate bond yields. And he might even have restricted
his attention to railroad bonds, the most important single class within
the corporate market ... Since 1900 the picture has radically changed,
and the American money markets have become far more complex ... (T)he
most revolutionary developments have occurred outside the corporate bond
market ... (and) include the phenomenal rise in the federal debt during
the great depression and World War II, which brought the United States
bond market to a position of pre-eminence."
suffices that the yield curve can predict future macroeconomic developments
without necessarily causing them."
The yield curve is perhaps the most important market-based indicator of recessionary expectations. It is a graph illustrating maturities and yields of treasuries. The yield curve's normal slope is positive, or upward sloping with short maturities at yields less than long treasuries. Until recently the bellwether long treasury was the 30-year bond. The U.S. government's decision to gradually purchase outstanding 30-year bonds means the 10-year note has emerged as the new bellwether in the market.
Inversion of the yield curve has preceded every recession since 1960. These include the recessions of 1960; 1969-70; 1974-75; 1980; 1981-82; and 1990-91. The only time recession did not occur following inversion of the yield curve was in 1966-67.
In the post-WWII bond market the yield curve has been recognized as a key economic indicator with implications for monetary policy. A positive, steeply sloping yield curve is evidence of inflationary expectations, a correlation long recognized in the bond market. Conversely, inversion of the yield curve is suggestive of recession.
Until recently, "explicit formulations of these connections, either in a policy or a research context," were "extremely rare," a 1990 New York Federal Reserve paper states. "(A) member of the Federal Reserve Board of Governors (has) affirmed that the yield curve is one of three major indicators that may be useful in formulating monetary policy." Governor Manuel Johnson (1988) said the Fed follows the yield curve, commodity prices and foreign exchange rates in setting monetary policy. The 1990 paper concludes "the yield curve has provided information about future real activity ... that may have been useful to both private observers and policy makers" These include bond traders, stock investors and the rare elected government official.
Inversion of the yield curve occurred in summer 2000. The relationship between the slope of the yield curve and GNP "cannot be easily interpreted in a causal manner," the 1990 Fed paper cautions. But viewed in the context of other market indicators and government data it takes on important significance.
Industrial Production and Manufacturing Base
The real economy consists of various sectors, including manufacturing, hi-tech and service. Contrary to popular media it is not synonymous with stock market indices. A key statistic of the real economy is industrial production, a fixed-weight measure of the physical output of the nation's factories, utilities and other heavy industry.
Contraction of industrial production for more than a quarter is recessionary. In the postwar era industrial production has never contracted for more than four consecutive months except when the U.S. economy was in recession. Yet it has now been in decline for nearly one year.
"Industrial production contracted 0.8 percent in May," the Fed reports. "After eight consecutive months of decline, industrial production in May was nearly 3 percent below its level in May 2000. Manufacturing output declined 0.7 percent. Excluding motor vehicles and parts production, manufacturing dropped 0.9 percent; the sector has declined more than 4-1/4 percent since November 2000."
Manufacturing output is the largest component of industrial production. It "fell 0.7 percent in May; after eight consecutive months of contraction, production in May was more than 4-1/2 percent below its level in September 2000," the Fed reports.
Preoccupation with the hi-tech sector, and asset-price deflation in the NASDAQ market index, which has declined more than 60 percent in value from its peak, should not obscure the ongoing contraction of the U.S. manufacturing base.
Unemployment Rate & Jobless Claims
Government economists have generally defined "full employment" in the postwar era at four- percent unemployment. Discouraged workers who have quit searching for employment because they believe additional any job search would be useless are not counted in government data. Wage flexibility and the emergence of a large service sector have undoubtedly contributed to the unemployment levels below four percent evident in the post-1991 expansion.
The jobless rate has never increased by more than 0.4 percentage points except in recession. In April it rose to 4.5 percent, an increase of 0.6 percent from September 2000. Low unemployment by historic standards does not preclude a recession. It has been common for the jobless rate to be low at the start of many postwar recessions.
Another measure of unemployment is the four-week moving average of individuals applying for first-time jobless benefits. The four-week moving average is a U.S. Labor Department index that tracks state unemployment filings. One report can be misleading so data is tracked on a four-week moving average to develop a more accurate view of the underlying trend. Data is also released by state. For example, the highest insured unemployment rates in the week ending May 26 were in Puerto Rico (5.7 percent), Alaska (4.5), Oregon (3.4), Washington (3.2), Pennsylvania (3.0) and Arkansas (2.8 percent). New cyclical highs nationally were reached in June, surpassing levels last seen in 1992. Revised figures for the June 7 period show 440,000 Americans filed for first-time unemployment benefits.
The rise of the four-week moving average is another sign of a weak U.S. economy.
The economic boom of the 1990s was not the postwar economic expansion of the 1950s and 1960s. The former was centered in the financial services and hi-tech sectors; the latter in manufacturing. The credit structure in place today is unlike any other in financial history, and will be viewed by future economic historians as unique.
One possible explanation can be found in the Cleveland Fed's 1998 annual report. An essay contained a two-sentence statement that resembles an overlooked interpretation of the business cycle that has been out-of-favor in most graduate business schools for the past quarter-century: "Accelerating money growth in the United States during the past few years might have been accommodating more than a burgeoning volume of dollar-based goods and services transactions around the world. Some portion of the expanding money supply might have been supporting increased asset prices including farm land, housing, and equity prices, but especially the latter." Or accelerating money growth and a unique credit structure with the power to increase liquidity, especially in the domestic housing market. It remains to be seen whether the asset-price deflation hinted at it in the second sentence extends beyond the NASDAQ ("equity prices") into the housing market ("farm land, housing"). One point is clear: too few officials are considering these potential consequences given record credit levels and a negative U.S. savings rate.
It appears from a macroeconomic perspective that a major sector of the economy—manufacturing--is in recession. Nearly every postwar U.S. recession first appeared among higher-order capital goods in the manufacturing sector. A strong case can be made the U.S. economy will enter recession in 2001. Thus, a proper economic policy response is important. The Fed’s monetary policy response has been to ease. One does not have to be a supply-side advocate to advocate tax cuts as the fiscal policy response to recession. Even within the Keynesian framework the proper fiscal response is to cut taxes and/or increase spending to stimulate GDP. It is ironic that critics of the Bush tax cut plan have ignored Keynes, the greatest liberal economist of the 20th Century, and his emphasis on the importance of fiscal, not monetary, policy in combating recession. The Bush tax cut is a very tentative but necessary fiscal policy.
The successful resolution of several other problems would improve the prospects for economic growth. First, there is the impact of higher energy costs in California, one-sixth the U.S. economy. Second, there is the record U.S. current account deficit. Finally, there are fundamental problems with the credit structure. These were last revealed in fall 1998 during the Long-Term Capital Management crisis. We say with great certainty they will be revealed again.
Arkansans should not be lulled into a false sense of security from popular media reports that equate stock market indices with the real economy. The current economic slowdown provides an opportunity for individuals and families to build the liquidity necessary to protect large assets and survive a recession.
Greg Kaza is executive director of the Arkansas Policy Foundation. He has a B.A. in economics and an M.S.F. in International Finance.