Thursday, January 07, 2016

What is a Recession?

A recession is a somewhat arbitrary declaration that economic growth has slipped below zero on a variety of measures.  Specifically, the National Bureau of Economic Research (NBER) declares the beginnings and endings of recessions, using the following metrics:

  • Nonfarm Employment
  • Industrial Production
  • Real Retail Sales
  • Real Personal Income (excluding Transfer Receipts)
But I have to the conclusion recession amounts to a general acknowledgement by the private sector that they've gotten ahead of themselves, and need to cut back. It becomes a socially acceptable time to lay people off, mark down the value of assets, etc. 

It seems that there are vested interests continuously fighting against the declaration of recession, and they can postpone the inevitable.  But over time more and more businesses find themselves putting up a better visible front than is warranted by the underlying business.  This is a natural outcome in our capitalistic system.  Weakness is often hidden.  Eventually, weakness becomes widespread enough that a consensus is formed on admitting a recession so that all businesses can put the bad behind them and start afresh.

The current economy environment provides a wonderful test case.  Clearly, there has been tremendous overinvestment around the globe.  While the global and U.S. economies continue to grow, growth has been much slower than normal and than predicted by all establishment economists.  As Bill McBride of Calculated Risk says, 2% is the new 4% (with regard to GDP growth).  

So there has been tremendous overinvestment and commodity prices are plunging.  Clearly, mining and manufacturing are already in recession, and this cannot be hidden.  Outside of manufacturing, growth continues (in the U.S.), albeit at the new normal rate of 2% instead of at the previously normal rate of 4%.   Some service industries, such as health care, are relative immune to the rest of the economy and therefore bring up the average.  But the average is pulled lower and ultimately the weakness infiltrates even the less sensitive areas of the economy.  

The global economy is not a zero sum affair.  Losses in one part of the economy are not automatically offsets by gains in another part of the economy.  For example, when the value of a corporation, as measured by its stock price, falls by 50%, there is no compensating gain of value anywhere else.  The proceeds of stock sales do not increase the sum of cash in circulation (cash is exchanged from one party to another when a stock is sold).  Rather, the wealth just evaporates.  So when mining and manufacturing sink, the overall economy sinks, and less wealth remains to finance purchases of services and assets.

From time to time a reset is needed in order to reset unaffordable debt and other hidden weaknesses in the economy.  As the Austrian economists say, this is necessary and good.  But, the government can and should counteract the effects of recession, not by bailing out the weak, but by providing a safety net and other public services.