WHAT IS A RECESSION AND IS ONE COMING?
THE FOLLOWING WAS DELIVERED AS A COMMENTARY OVER WAMC RADIO IN DECEMBER OF 2007 BY MICHAEL MEEROPOL
You hear a lot these days about fears of a recession -- But what is a recession and why would we want to avoid one? A recession is defined as a period of at least six months when the total output of society declines. 1
During a recession incomes fall for a large percentage of the population. More significantly: some people lose their jobs, some people are forced to work part time when they want to work full time, some businesses fail. 2
However, the loss to the economy affects everyone, not just the unemployed. A recession is a waste of human resources. A person who is unemployed for a year has continued to live and grow older. That year of potential contributions to society (as a factory worker, retail clerk, fire-fighter, social worker, you name it) is lost forever. Economists call this the Gross Domestic Product gap - the output that is lost whenever the economy underperforms. 3
During the 20th century, there were 20 recessions in the US. The economy lost on average the equivalent of three months of GDP in each of them. 4 In 2006, the GDP was 13 trillion dollars. 25% of that is $5.2 trillion. It is this reduction in output that affects everyone. Maybe a person won't lose his or her job but will have reduced overtime. Workers in state or city government won't get raises because revenues are down. Business profits may fall - or, the business may lose money. Remember, the reduced output in a recession is output that can never be recouped.
The fears expressed by policy-makers and experts have focused on three things happening at once, two of which are closely related. The two closely related problems are first the deflation of the housing bubble which is causing a significant reduction in home sales, home prices and construction activity; and, second, a credit crunch which is causing lenders to shy away from granting credit to all but the most trustworthy potential borrowers.5
I have spoken about the housing bubble before and given the nature of the headlines, it is probably unnecessary for me to say anything more than that the current fall is unprecedented. The bad news is the fall in housing sales and prices has just begun.
The credit crunch is caused in part by the nature of the housing bubble. Because mortgages have been securitized the bank that issued the mortgage rarely holds on to it. Because many mortgages (and parts of mortgages) have been rolled into securities and sold as packages, the holders of these securities are beginning to wonder how many of the mortgages represented by those securities are bad. No one wants to buy any more of these securities, and institutions sitting on these assets are already worried about having to write them down - that is reduce the value the owners expect to realize. Fearing that they're already overextended, these financial institutions are worried about making new loans. These two problems are sure to depress both consumption and investment in the coming months.6
The third problem that is making people fear a recession is the volatility in the price of oil. Here in the Northeast we are looking at a 20% or more increase in the price of home heating oil for this coming winter.
Unleaded regular gasoline is consistently at or above $3.00 per gallon and could go higher. Any significant rise in the price of gasoline and home heating oil will cut into consumption spending even further while raising the cost of doing business, thereby dampening profits as well. 7
With consumption likely to decline and investment likely to follow, I am afraid a recession is inevitable. The question is, will the Federal Reserve and the federal government take remedial steps quickly enough to make sure it is short and shallow rather than deep and devastating. 8
Footnotes:
1 See SURRENDER, 284-5 for a discussion of the term recession and the dating of recessions from 1948 through 1991. See pp. 21-22 for a general discussion of the business cycle. Before the 1930s, economists used to divide the business cycle into four phases: The upswing when the economy was doing really well, the recession when it was starting to go down after reaching its peak, the depression when it was stuck at the bottom, and the recovery when it was starting to grow after hitting bottom. The Great Depression of the 1930s was so traumatic for the US economy (and the citizenry as a whole) that after World War II it became fashionable never to use the term "depression" in describing economic activity. Thus, we have used the word "recession" to describe the interruptions in economic growth that have occurred since the war and have (for the moment) shelved the word "depression."
2For a rather typical textbook discussion of recessions, etc. see PRINCIPLES OF MACROECONOMICS by Karl Case and Ray Fair (Upper Saddle River, NJ: Pearson, Prentice-Hall, 2007): 134-143. There is even a reference to the potential benefit of a recession - namely the ability to reduce inflation. This is actually quite a controversial point. There are those that argue that if recession reduces inflation, that might increase economic growth in the future over and above what it would have been if the inflation had not been reduced.
3 Notice that this assertion runs counter to the point mentioned briefly in footnote 2. I am well aware of that argument, I just do not find it convincing.
4 In an article entitled "When the Economy Goes South" by Jane Katz in the Regional Review published by the Federal Reserve Bank of Boston (http://www.bos.frb.org/economic/nerr/rr1999/q3/katz99_3.htm) there is a table identifying 20th century recessions in the US with a column for production lost in months. These recessions averaged 11 months and lost on average 3.1 months of output. The recession in the 21st century began, according to the National Bureau of Economic Research in March of 2001 and ended in November of 2001. See http://www.nber.org/cycles/cyclesmain.html.
5 There are so many references to these issues that the best advice I can give is to use Google to search for articles about "the Housing bubble" and "the credit crunch." Here are a couple of examples: "3 Big Banks See No Relief as Write-Offs Mount" The New York Times Dec 13, 2007: C7. "Central Bankers to Lend Billions in Credit Crisis" The New York Times Dec 13, 2007: A1 "Big Banks Scale Back Plan to Aid in Debt Crisis," The New York Times Dec 10, 2007: C1. For a recent summary see Paul Krugman, "After the Money's Gone" The New York Times Dec 14, 2007: A35. 6 Consumption has been very strong since the 2001 recession in large part because the increased value of homes made it possible for individuals to take out loans using that increased value as collateral. Thus, consumption as a percentage of GDP held steady at 70% as GDP grew after the recession. If consumption growth slackens, which is virtually inevitable, GDP will also. Meanwhile, investment as a percentage of GDP rose from 15% in 2002 to 16.7% in 2006. (This 1.7% change is quite significant - it represented over $132 billion!). See http://www.bea.gov/national/nipaweb/TableView.asp#Mid. For discussion of how this will negatively affect the economy, see Mark Weisbrot: "Housing Crash Still Weights Heavily on the Economy" Center for Economic Policy Research, December 12, 2007.
7 Any decline in profits will reduce investment incentives. In addition, any decline in profits will cause businesses to reduce their predictions of future profits. It is these dampened expectations of future profits that have even more of an impact on investment decisions.
8 For the behavior of the FED see "Credit Crisis Prompts FED to Roll Back Rates Again," The New York Times, December 12, 2007, p. C1. Unfortunately, many investors felt that the Fed's action was too little too late as evidenced from the stock market decline that very day. That was why the world Central Bankers stepped in - see "Central Bankers to Lend Billions in Credit Crisis" The New York Times Dec 13, 2007 from footnote 5 above. In this context, the recent Republican debate where all candidates spoke of the need to cut government spending was very disappointing. Equally disappointing were some Democrats who insist on maintaining the "PAYGO" rules regarding government expenditure. As anyone who has taken one course in economics ought to know, during a recession the important role of government is to INCREASE its spending and/or DECREASE it's taxation to counter the declines in consumption and investment that are causing the recession.
You hear a lot these days about fears of a recession -- But what is a recession and why would we want to avoid one? A recession is defined as a period of at least six months when the total output of society declines. 1
During a recession incomes fall for a large percentage of the population. More significantly: some people lose their jobs, some people are forced to work part time when they want to work full time, some businesses fail. 2
However, the loss to the economy affects everyone, not just the unemployed. A recession is a waste of human resources. A person who is unemployed for a year has continued to live and grow older. That year of potential contributions to society (as a factory worker, retail clerk, fire-fighter, social worker, you name it) is lost forever. Economists call this the Gross Domestic Product gap - the output that is lost whenever the economy underperforms. 3
During the 20th century, there were 20 recessions in the US. The economy lost on average the equivalent of three months of GDP in each of them. 4 In 2006, the GDP was 13 trillion dollars. 25% of that is $5.2 trillion. It is this reduction in output that affects everyone. Maybe a person won't lose his or her job but will have reduced overtime. Workers in state or city government won't get raises because revenues are down. Business profits may fall - or, the business may lose money. Remember, the reduced output in a recession is output that can never be recouped.
The fears expressed by policy-makers and experts have focused on three things happening at once, two of which are closely related. The two closely related problems are first the deflation of the housing bubble which is causing a significant reduction in home sales, home prices and construction activity; and, second, a credit crunch which is causing lenders to shy away from granting credit to all but the most trustworthy potential borrowers.5
I have spoken about the housing bubble before and given the nature of the headlines, it is probably unnecessary for me to say anything more than that the current fall is unprecedented. The bad news is the fall in housing sales and prices has just begun.
The credit crunch is caused in part by the nature of the housing bubble. Because mortgages have been securitized the bank that issued the mortgage rarely holds on to it. Because many mortgages (and parts of mortgages) have been rolled into securities and sold as packages, the holders of these securities are beginning to wonder how many of the mortgages represented by those securities are bad. No one wants to buy any more of these securities, and institutions sitting on these assets are already worried about having to write them down - that is reduce the value the owners expect to realize. Fearing that they're already overextended, these financial institutions are worried about making new loans. These two problems are sure to depress both consumption and investment in the coming months.6
The third problem that is making people fear a recession is the volatility in the price of oil. Here in the Northeast we are looking at a 20% or more increase in the price of home heating oil for this coming winter.
Unleaded regular gasoline is consistently at or above $3.00 per gallon and could go higher. Any significant rise in the price of gasoline and home heating oil will cut into consumption spending even further while raising the cost of doing business, thereby dampening profits as well. 7
With consumption likely to decline and investment likely to follow, I am afraid a recession is inevitable. The question is, will the Federal Reserve and the federal government take remedial steps quickly enough to make sure it is short and shallow rather than deep and devastating. 8
Footnotes:
1 See SURRENDER, 284-5 for a discussion of the term recession and the dating of recessions from 1948 through 1991. See pp. 21-22 for a general discussion of the business cycle. Before the 1930s, economists used to divide the business cycle into four phases: The upswing when the economy was doing really well, the recession when it was starting to go down after reaching its peak, the depression when it was stuck at the bottom, and the recovery when it was starting to grow after hitting bottom. The Great Depression of the 1930s was so traumatic for the US economy (and the citizenry as a whole) that after World War II it became fashionable never to use the term "depression" in describing economic activity. Thus, we have used the word "recession" to describe the interruptions in economic growth that have occurred since the war and have (for the moment) shelved the word "depression."
2For a rather typical textbook discussion of recessions, etc. see PRINCIPLES OF MACROECONOMICS by Karl Case and Ray Fair (Upper Saddle River, NJ: Pearson, Prentice-Hall, 2007): 134-143. There is even a reference to the potential benefit of a recession - namely the ability to reduce inflation. This is actually quite a controversial point. There are those that argue that if recession reduces inflation, that might increase economic growth in the future over and above what it would have been if the inflation had not been reduced.
3 Notice that this assertion runs counter to the point mentioned briefly in footnote 2. I am well aware of that argument, I just do not find it convincing.
4 In an article entitled "When the Economy Goes South" by Jane Katz in the Regional Review published by the Federal Reserve Bank of Boston (http://www.bos.frb.org/economic/nerr/rr1999/q3/katz99_3.htm) there is a table identifying 20th century recessions in the US with a column for production lost in months. These recessions averaged 11 months and lost on average 3.1 months of output. The recession in the 21st century began, according to the National Bureau of Economic Research in March of 2001 and ended in November of 2001. See http://www.nber.org/cycles/cyclesmain.html.
5 There are so many references to these issues that the best advice I can give is to use Google to search for articles about "the Housing bubble" and "the credit crunch." Here are a couple of examples: "3 Big Banks See No Relief as Write-Offs Mount" The New York Times Dec 13, 2007: C7. "Central Bankers to Lend Billions in Credit Crisis" The New York Times Dec 13, 2007: A1 "Big Banks Scale Back Plan to Aid in Debt Crisis," The New York Times Dec 10, 2007: C1. For a recent summary see Paul Krugman, "After the Money's Gone" The New York Times Dec 14, 2007: A35. 6 Consumption has been very strong since the 2001 recession in large part because the increased value of homes made it possible for individuals to take out loans using that increased value as collateral. Thus, consumption as a percentage of GDP held steady at 70% as GDP grew after the recession. If consumption growth slackens, which is virtually inevitable, GDP will also. Meanwhile, investment as a percentage of GDP rose from 15% in 2002 to 16.7% in 2006. (This 1.7% change is quite significant - it represented over $132 billion!). See http://www.bea.gov/national/nipaweb/TableView.asp#Mid. For discussion of how this will negatively affect the economy, see Mark Weisbrot: "Housing Crash Still Weights Heavily on the Economy" Center for Economic Policy Research, December 12, 2007.
7 Any decline in profits will reduce investment incentives. In addition, any decline in profits will cause businesses to reduce their predictions of future profits. It is these dampened expectations of future profits that have even more of an impact on investment decisions.
8 For the behavior of the FED see "Credit Crisis Prompts FED to Roll Back Rates Again," The New York Times, December 12, 2007, p. C1. Unfortunately, many investors felt that the Fed's action was too little too late as evidenced from the stock market decline that very day. That was why the world Central Bankers stepped in - see "Central Bankers to Lend Billions in Credit Crisis" The New York Times Dec 13, 2007 from footnote 5 above. In this context, the recent Republican debate where all candidates spoke of the need to cut government spending was very disappointing. Equally disappointing were some Democrats who insist on maintaining the "PAYGO" rules regarding government expenditure. As anyone who has taken one course in economics ought to know, during a recession the important role of government is to INCREASE its spending and/or DECREASE it's taxation to counter the declines in consumption and investment that are causing the recession.
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