From the October 2011 issue of Investment Advisor • Subscribe!

Recession Imminent?

Are we facing a double-dip recession?

Illustration by Robert Carter Illustration by Robert Carter

The U.S. economy is a highly complex, multifaceted mechanism. Accordingly, it is extremely difficult to predict. It is so difficult, in fact, that economists have been the subjects of numerous jokes over the years. Economic predictions are frequently unreliable, despite the fact that many economists prognosticate with great confidence.

Economists routinely sift through mountains of data to determine their forecast. Recently, I spoke with Richard Yamarone, an economist with Bloomberg who, earlier this year, was perhaps the first to proclaim that another recession was on the horizon. Yamarone’s contention is that a recession in the United States is a certainty by year-end. Part of his reasoning is that since 1948, whenever real GDP fell below 2% on a year-over-year basis, the economy ultimately slipped into recession. With America still reeling from the Great Recession of 2008, perhaps Yamarone has a case.

Politically, a double-dip could send many Washington incumbents packing. Economically, a double-dip would translate into higher unemployment and could introduce the potential for a Japanese-style deflationary scenario. At least that’s what the Fed was claiming last year when we stood at this same precipice.

The Business Cycle: A Primer

When the economy expands, unemployment falls as businesses hire to meet the growing demand. At some point, and for a variety of reasons, demand ultimately slows and the economy begins to contract.

As the economy contracts, unemployment rises, GDP falls and eventually we reach the bottom of the cycle. Expansion and contraction may last for as little as a few months or up to several years. In fact, between 1854 and 2009, the shortest U.S. expansion lasted 10 months while the shortest contraction was six months. The longest expansion was 120 months and the longest contraction was 65 months. Since WWII, the average economic expansion has lasted 42 months and the average contraction 16 months.

There is a strong psychological component to the business cycle as it is subject to the whims of the individual. Furthermore, it is influenced by world economies. In effect, when individuals feel bad about the economy they tend to delay major purchases. To the contrary, when times are good, people spend more. Both of these can be self-perpetuating, which is part of the reason why the business cycle pendulum has wide swings in both directions. Therefore, maintaining a steady economy is more ideological than obtainable. Ideally, if all major purchases could somehow be made with consistency and regularity, the business cycle would be rather flat. However, due to human emotions, government involvement, military conflicts, weather, etc., this is unrealistic. Hence, the gyrations of the business cycle remain.

The Business Cycle: Antagonists

As previously mentioned, the business cycle is influenced by a number of factors, notwithstanding government policies. Prior to FDR, the U.S. government assumed a much more hands-off approach. For example, when the banking crisis of 1907 hit, the private sector, namely J. Pierpont Morgan, stepped in to rescue the economy. However, by the time the Great Depression arrived, Morgan was no longer around. There was also a concern that too much power had been vested in one individual. Therefore, in response to a strong public outcry, government was compelled to act. America was searching for answers and in the early 1930s, noted British economist John Maynard Keynes provided them. Keynes believed that during slow economic times, the government should step in and employ the unemployed. FDR welcomed this idea with open arms as evidenced by his “New Deal” economic plan. Since then, government involvement in economic affairs has been the rule rather than the exception.

It is in the darkest of times that politicians find their greatest opportunity. In fact, it was Otto von Bismarck who in the late 1800s postulated, “A man who has a pension for his old age is much easier to deal with than a man without that prospect.” He went on to say, “Whoever embraces this idea will come to power.” Need I say more?

GDP 101

The business cycle ebbs and flows based on GDP. Gross domestic product is the primary measure of the economy and is defined as the “total market value of all goods and services produced.” Moreover, it is comprised of four distinct, but interrelated parts. They are: consumer spending, industry spending, government spending and net exports. You might think of it as: C + I + G + Ex. The sum of these parts is the key metric for measuring our economy.

Unemployment Rate: The Fallacy Behind the Figures

The unemployment rate is measured by the Bureau of Labor Statistics and is published on a monthly basis. At the time of this writing, the rate was 9.1%. The unemployment rate has been higher than 8.8% for 28 months since April 2009.

There are actually two unemployment rates: the “official” rate and the “unofficial” rate. The official rate is the rate quoted most often by the media. The unofficial rate attempts to include those individuals who have stopped looking for employment. Obviously, this number cannot be accurately determined, but suffice it to say that the unofficial rate is always higher than the official rate. The divergence between the two may also increase as the economy worsens and people become more discouraged.

A healthy economy is heavily reliant on the labor market. Clearly, the more individuals who are employed, the greater the output will be. Therefore, putting people back to work is perhaps the single most important economic issue today. Until we reduce the unemployment rate, robust economic growth is unlikely.

Recession Defined

A recession is generally defined as a prolonged downturn in economic activity as measured by GDP. The National Bureau of Economic Research in Cambridge, Mass., is widely held to be the organization that establishes the inflection points in the economic cycle. Moreover, the determination of these inflection points is always made months after the fact as economic data is compiled, revised and revised again.

When recessions occur, it is because of a slowdown in economic activity. Yamarone of Bloomberg equates this to someone riding a bicycle. “If you peddle too slowly, the bike will tip over,” he says.

No two recessions are exactly alike. Although they share many similarities, they differ in terms of severity and duration. The magnitude of a recession is also influenced by the degree of the prior expansion. For example, the 2008 Great Recession followed the greatest credit bubble of all time. In fact, the bursting of the bubble was so severe that we lost over eight million jobs and are still more than six million jobs short of fully recovering.

Employment and Recessions

As economic activity slows, businesses begin to reduce their labor force in order to remain profitable. This decline may be sparked by a decrease in consumer spending, which comprises about two-thirds of GDP. As demand slows, layoffs increase and the unemployment rate rises. As the unemployment rate rises, there are fewer wage earners to support the economy and spending falls. As spending falls, businesses reduce their labor force and the self-perpetuation begins. Before the economy can recover, confidence must be restored.

Fiscal and Monetary Policy

Monetary policy is determined by the Federal Reserve which was established in 1913. The Fed has a dual mandate: full employment and stable prices. Their tools include raising and lowering interest rates; expanding and contracting the money supply; and raising and lowering bank reserve requirements. At this point in our economy, rates are as low as they can go, the money supply has ballooned to record levels and bank reserve requirements are also very low. In essence, there isn’t much else the Fed can do to stimulate economic growth. Where is all this excess money? Much of it is sitting at the Federal Reserve banks and the commercial banks. Why isn’t the consumer borrowing more? Bank lending standards are extremely tight and consumers have too much debt, therefore, lending activity is muted. Even though money is very cheap these days, throwing more of it into the system may not motivate the consumer to resume their pre-recession spending habits.

Last year, the Fed tried to stimulate consumer spending with QE2, but had little success. In my view, QE2 was a game of cat and mouse with confidence as the cheese. However, the consumer didn’t take the bait. Ironically, higher prices have suppressed economic growth. The real problem here is that individuals are still overleveraged and consumer confidence is low.

Fiscal policy has two main components: government expenditures and tax policy. We have had massive overspending for a number of years. When we hear discussions about raising taxes because government needs the revenue, the clear signal is that government is more important than the American economy. If government cannot operate on $2.2 trillion annually, then we have a much bigger problem.

U.S. Recessions

U.S. RecessionsThe table includes data for each U.S. recession since 1929. As a baseline, since Oct. 1, 1928, there have been slightly more positive days in the stock market than negative ones (52% compared with 48%). Moreover, the average daily gain (0.74%) and loss percentages (-0.76%) are nearly identical. Normally, stocks decline during the early stage of a recession and begin to advance before the recession ends. However, in the recession of 1945, stocks trended higher as they did during the recession of 1953. Also, in the recession of late 1948, stocks rebounded to their pre-recession level by the time it ended. Other than these few exceptions, stocks have not performed well during these economic downturns.

Where Do We Go From Here?

Over the past few years, government has been trying to “push the string uphill” by addressing the demand side of the equation through the expansion of the money supply. Historically, this along with a lower cost of borrowing has helped to stimulate economic expansion. However, the consumer hasn’t yet taken the bait to any significant degree. What can government do to aid our ailing economy and what has been done?

Congress has extended the “Bush” tax cuts and temporarily reduced the Social Security withholding tax, but much of the talk in Washington has been about finding alternate sources of revenue. Again, I think they should be able to function on $2 trillion per year, don’t you?

There’s really nothing more that the Fed can do; it’s up to Congress and the president to act. It’s time to put more money into the hands of the consumer. After paying down debt and building up their savings, consumers will do what they do well—spend. This may cause a short-term rise in our debt, but eventually, when the consumer gets back into the game, the economy will grow and we’ll escape this mess.          

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