How Exactly Do We Determine Recessions?

There seems to be this idea that just won’t go away — that two or more quarters of negative economic growth mark a recession. This is, of course, incorrect. But it persists, and seems to get new life with every unsettling economic event, because people don’t understand the basics surrounding what an economic contraction is or how we measure it.

The state of the economy, unsurprisingly, is significant to stock and bond markets. Unfortunately, by the time we learn that we are in a recession, it often is too late to make significant portfolio adjustments, as the stock market typically has already lost value and the bond market is in full rally mode.

Last month, we talked about how we can judge the health of an economy by “its ability to absorb a blow, and shake it off.” Several negative factors — bad payroll data, the Brexit vote, a flattening yield curve — have led some analysts to suggest that a U.S. recession was increasingly likely. They have an easy time imagining a scenario with two straight quarters of negative growth.

They are using an outdated recession definition. Given the nature of the post-credit-crisis recovery — debt deleveraging, slow gross domestic product growth, weak retail sales — this misunderstanding is significant.

Maybe the traditional definition of a recession was meaningful a half-century ago, but it no longer is relevant. The official definition comes from the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee.

How the NBER, which was founded in 1920, became the official arbiter of recession dating was detailed by economist Carol Carson in 1975:

Its first staff economist, director of research, and one of its founders was American economist Wesley Mitchell. The Russian American economist Simon Kuznets, and student of Mitchell, was working at the NBER when the U.S. government recruited him to oversee the production of the first official estimates of national income, published in 1934. In the early 1940s, Kuznets’ work on national income became the basis of official measurements of GNP and other related indices of economic activity.

Having an objective, academic body determine the beginning and end of a recession is a good thing. As historian Bruce Bartlett explained in the New York Times, “the N.B.E.R. is the official arbiter of when a recession begins and ends because leaving such a task to the government would inevitably politicize it.”

Let’s delve into the details of the NBER recession definition. It is described as:  

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.  

So why not just use the two quarters of negative GDP growth as a fast and easy measure? The reason is that using GDP as the lone benchmark would lead to incorrectly classifying certain slowdowns in economic expansions as a recession. That same measure also would have missed actual recessions. It is noteworthy that while most of the recessions identified by NBER do consist of two or more quarters of declining real GDP, not all of them do.

The explanation for why GDP alone isn’t a full or complete yardstick of economic activity is straight-forward. The NBER’s research on measuring the economy — it has published more than 20,000 white papers on the subject — shows that including factors such as real income, employment, industrial production and wholesale and retail sales, produces a measure that is both more accurate and precise than GDP alone.  (The NBER’s FAQ details four specific reasons why two consecutive quarters of negative GDP is insufficient to identify a recession).

Perhaps most important, the determination that is made by the NBER to date the start and finish of recessions is based on publicly available data. You can track the exact same factors the NBER does, and estimate the dates of when the NBER will officially call a recession with some degree of confidence.

On the other hand, if you want a simpler recession explanation, let me suggest the one used by the Economic Cycle Research Institute, a private-sector research firm. It notes that the economy, “in order to signal a genuine turn in the cycle, must change direction in a way that is pronounced, pervasive, and persistent.”

Understanding when a recession begins and ends is a useful bit of information for investors. Whether it will make you any money is another issue.



Originally: That’s Your Idea of a Recession? Keep Trying



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