Sunday, April 3, 2016

The Recession Template, Except there Isn’t One

Barry Ritholtz reassures us that there’s no recession on the horizon.  He could be right, but his argument isn’t.  He says that the business cycle follows a predictable pattern: after its drubbing in the latest downturn, the economy slowly picks up steam.  Growth accelerates and unemployment falls.  Wages rise.  Eventually inflation breaches the central bank’s target, and interest rates are hiked to cool things down.  That’s when we get another recession.  Since wages have barely begun to move, inflation is minimal, and interest rates are scraping bottom, we can be sure that we are a long way from the next slump.

Sounds good, except it imposes a single model on business cycles, when in fact they don’t all fit in one box.  There are three different kinds of cycles, as helpfully laid out in an exemplary textbook I’m familiar with.  One is the policy cycle, as described by Ritholtz.  Yes, that one is flashing a steady green.  The second is the investment/profit cycle, whose theoretical basis goes back to Marx, includes Samuelson’s accelerator model, and is driven by the interaction of business costs (including wages), demand, and new investment.  The key indicator there is of course profit (and expected profit), and there are no clouds on that horizon at the moment.  The third is the financial cycle, of which 2008 was the most recent example.  Instability of that sort results from credit growth that props up asset prices rather than increasing revenues or from mismatches between liabilities and revenues.  In theory it’s possible to see this kind of trouble in advance, although the actual record is spotty.  If we are in for a crunch within the coming year it will probably come from financial forces.

The bottom line is that there are different kinds of business cycles that display different patterns.  You can’t show that one type is signaling expansion and conclude that risk is minimal.  I don’t put any effort myself into forecasting, and I have no idea how likely a recession is in 2016.  People ask me, and I say something like one in three, but that’s just an uninformed prior.


ProGrowthLiberal said...

"Most important of all to the cycle is the start of inflation. Once we see a few consecutive quarters of higher prices, the economy begins to overheat. This forces the Fed to pay attention and eventually to act. Fear of inflation scares the Fed into a tightening cycle; typically, it will tighten at three, four or even five meetings in a row. This reduces available credit, makes the credit that is available more expensive, and — voila! — a recession occurs."

Is Barry stuck in the 1970's? The Great Recession did not follow this pattern. Even the Great Depression was not caused by the FED trying to lower accelerating inflation. While the 1920/21 recession was FED induced like the 1981/82 was, it was an elevated price level and not a rising price level that got the FED to squeeze. And I trust Barry knows that we had not yet fully closed the output gap when Volcker slammed on the brakes in 1981. Not all recessions are a like and Barry seems to have missed the boat on US macroeconomic history.

Bill said...

Can we have crash in the financial cycle without much impact on the rest of the economy? Like 1987?

ProGrowthLiberal said...

Bill - yes!

The old Paul Samuelson joke:
Economist Paul Samuelson used his Newsweek column of September 19, 1966 to show that the market and that economists often get things wrong: “Wall Street indexes predicted nine out of the last five recessions.”

I think this was updated to read 18 of the last 12 recessions. said...

Well, quite a few people did see that there was a housing bubble, although the number who foresaw that its collapse would lead to as big a general economic downturn as ended up experiencing was much smaller.

Philip said...

The Great Depression, the Great Recession, and Japan's Lost Decade were all triggered by crashes in financial asset markets, not by problems in the real economy. So you are right in saying that even when real economy indicators seem to show that everything is healthy there could be major trouble looming.

As the graph on A major crash is on the cards this year shows, if the fall in money growth continues as it has since January 2014, we can certainly expect a major crash towards the end of this year

Bill said...

ProGrowthLiberal - Thanks! :)

Thornton Hall said...

Hari Seldon lives!

Detroit Dan said...

Profits are already in recession. Behind U.S. GDP Data Is Reason for Recession Worry: Weak Profits: "Corporate profits plunged 11.5 percent in the fourth quarter from the year-ago period, the biggest drop since a 31 percent collapse at the end of 2008 during the height of the financial crisis. For 2015 as a whole, pretax earnings fell 3.1 percent, the most in seven years, according to the Commerce Department.
That’s “bad news,” said Nariman Behravesh, chief economist for IHS Inc. in Lexington, Massachusetts. History shows that when earnings fall, the economy often follows them downward into recession as profit-starved companies cut back on hiring and investment."

But you say, "The key indicator there is of course profit (and expected profit), and there are no clouds on that horizon at the moment."

Myrtle Blackwood said...

There are cycles and there are precipices. The Climatologists are urging the Economists to implement an immediate Marshall Plan. It's an emergency.

Paul Beckwith: "I think that the Arctic will start to have ice-free conditions at the end of the melt season (Septembers) as early as 2020 or before (possibly even the summer of 2016)....Once the Arctic is essentially ice-free for ever-increasing durations in the summer months, and then over the entire year, there are two enormous feedback risks that we face — Methane and Greenland.Methane is the mother of all risks.....a large burst of methane can virtually warm the planet many degrees almost overnight....Greenland ice melt is the next enormous feedback risk. When we lose snow and ice in the Arctic – and the cascading feedbacks like albedo destruction kick in – and the methane comes out, then the enormous warming over Greenland and in the water around and under the Greenland ice will viciously destroy the ice there and greatly accelerate sea level rise...The level of certainty over these future effects is close to 100% if we continue to be stupid and do nothing. If we are smart, we need to have a Manhattan–Marshall Plan-like emergency status to a) Zero emissions as soon as possible, i.e. by 2030; b) Cool the Arctic to keep the methane in place and restore jet stream stability, and c) Remove CO2 from the atmosphere/ocean system and remove methane from the atmosphere. There is no other choice."

The discussion needs to move away from cycles and recessions to epochs and ways to avoid catastrophe.