What is a recession?

[geoffrey]

There has been a lot of nervous hand-wringing over the possibility of a recession in the US economy lately, and I wonder if a good part of the brewhaha doesn't stem from a fundamental confusion about the definition of the term. A recession is a contraction of the economy and is defined as two consecutive quarters of negative growth in gross domestic product (GDP). GDP is a measure of the total value of goods and services produced by an economy over a given period. So, for example, if someone says "GDP grew by 3% this year," that means that the country produced 3% more stuff this year than it did last year. A recession occurs when GDP falls below zero for two straight quarters. Ie, for two straight quarters, the country produces less stuff than it did the previous quarter. To get a sense of how often that happens, the US economy has only experienced three quarters of negative GDP growth in this decade.

Now, notice how nothing in the definition of recession or GDP has anything to do with the stock market. Then consider what people have been saying recently: that the stock market has been suffering because of the sub-prime mortgage crisis, which could in turn, drag the US into a recession. We know this sentiment is utterly meaningless because the stock market has nothing to do with the definition of recession, but maybe there is some association between the stock market and GDP, such that a declining stock market would correlate with a recession.

To test for such a correlation, consider the graph below. I have plotted annualized GDP growth vs. quarterly growth of the S&P for every quarter since 2000. The vertical axis is percentage growth and the horizontal axis is time. The blue bars are GDP and the red are the S&P.

There are a few interesting features to note. First, we have not seen two consecutive quarters of negative GDP growth this decade. Hence, we have not been in recession this entire decade (despite the popular opinion that the bursting of the dot com bubble induced a recession). Second, the S&P is much more volatile than GDP. Hence, it is not such a big deal that the S&P has tumbled 10 percentage points in six months- the S&P experiences 10-point swings all the time. And thirdly, the two series do not seem to track each other at all.

In fact, the correlation between S&P growth and GDP growth this decade is a paltry 0.25. Now, maybe these series correlate on a lag. That is, perhaps negative S&P growth this quarter induces negative GDP growth next quarter. When I correlate GDP with S&P lagged by one quarter, correlation drops to 0.04! That means the lag of S&P is not related to GDP at all!

So, bottom line, if recent history is any guide, the shake-up in the stock market at the end of 2007 and beginning of 2008 should in no way indicate the beginning of a recession.

Does that mean we are not heading into a recession? No. It's just that you can't tell from watching the stock market.

[Geno C]

Why don't you forward this on over to Bernanke? And while you're at it, explain that he can't reduce the interest rate below zero.

[geoffrey]

It would be sweet though- the bank pays you to take a loan.

[Christine C]

I’m not really up to date on the economic history of Japan, but its starting to feel like I should read up on it--I'm pretty sure they tried to do things which would have the same effect as reducing the interest rate below zero in Japan. Although they had very opposite problems there (eg "excessive" savings and not enough consumer spending to spur the economy, whereas the US has a negative savings rate -- which a negative interest rate will presumable only exacerbate) Also check out the Posner/Becker blog for interesting economics discussions http://www.becker-posner-blog.com/

[geoffrey]

Thanks for the blog rec. I'll check it out.

[yue]

If my memory serves me right, the Japanese had negative inflation for years. It essentially led to negative real interest rates.

[Nadav]

Thanks for the definition and the enlightening data analysis. I would point out, though, that the use of "recession" by commentators and the public does not necessarily track the formal definition, as happens frequently. Your observation that the burst of the dot com bubble did not technically qualify as a recession illustrates the point. The economy can experience a lot of hurt without inducing negative GDP growth. In the case of the economic downturn (is that better?) facing us today, I would argue that the potential for real world effects is far greater than in 2000. The drop in home prices, which many argue has only begun, has the potential to wipe out the value of the most significant asset for most Americans. Mortgage defaults and foreclosures have already rendered much of the trillions of dollars in securitized mortgages valueless, or close to it, and the resulting losses to financial institutions have led to a "credit crunch" that could stifle growth for some time to come. Furthermore, a contraction in the financial services sector represents a major blow to one of the cornerstones of our economy, with all the job losses and secondary effects that will surely entail. So in short, by the time this subprime crisis has rippled through the economy, it may very well cause damage large enough to reach your average joe, and not just your average stockholder.
But that's just armchair economics derived mostly from newspaper articles. It's not like I used to work for the Fed or anything.

[geoffrey]

Touche Nadav. I think you are right. There are plenty of good reasons to believe we are heading into a recession. But I find it pretty interesting that the stock market hardly correlates with economic growth at all. I'm told this is famously true among Economists, but I suspect little known outside of that world. And I'm sure they would hire you at the Fed.

[yue]

Stock market is much more volatile than GDP. Animal spirit display a lot of power there. However, a stock value implies people's expectation on a company's future profits or value. Those indices, therefore, to some extent reflect people's expectation on future economy. People's expectation will affect their behavior--consumption, investment, inventory accumulation...Guess, that is why people like to relate stock market performance with economy growth prospect. In that sense, the changes in stock market should proceed changes in GDP if there is any correlation between the two.

[John]

Let me begin by noting I am not an economist, it would be more accurate to state I am a political/economic philospher, however this statement would also be inaccurate.

That The S&P index does not correlate to the GDP is interesting and informative as I assume your graph is accurate.

I will accept that this is the case and therefore this instructs us that production from domestic labor is not a primary causal factor involved in tracting major investments. [No wonder labor both physical and intellectual has for the most part been, dare I say, exploited- (without sounding sophmoric?)

Hmm- Global investments or markets have been in place for many, many years. It appears that perhaps only 60 or more years ago, domestic labor may have played more of a significant role in relation to the S&P or "Wall-Street" and thereby Union/Management (that always play hand in hand) relations were more required and this is perhaps why people in the labor force were able to provide a somewhat better standard of living for their families.

It may be anacronistic to expect labor (both physical and intellectual) to benefit from the ever emerging global economy. In its strict structual existence, capitalism must ever seek new markets, be it geographical or abstract in order that it does not implode upon itself. If people wish it to be other wise, one should take heed in the words of Karl Marx: "Take from an institution it's power of exclusion and it ceases to exist."

The expectations of those who wish to believe that the economic sytem works equal for all who have the "right-stuff," will be suffering without really knowing what is actually causing this suffering. As many have previously noted; The strength of democracy is that it offers the illusion of freedom.

From this understanding, the media's purpose will be to pick"scape-goats" if you will as in the over played emphasis on "Fannie May, and Freddie Mac." Many people wanting to find something other than the obfuscated source of the problem, will blame those "little" people who were granted morgages from those poor innocent banks that were forced to grant loans to people who were not in a situation to pay back with interest. It is many times that the relative powerless become blamed for having the power to bring something down.

Your graph and analysis sir, were enlightening and apparently objective, I only hope you have the termerity to find this little diatribe also enlightening- Not neccessarily objective, as it is somewhat abstract in it's anaylsis, however; please do not dismiss out of a need to remain psychically sound by seeing this essay as only sophmoric.

Consider, think and respond.

[Adam H Klein]

Your analysis is brilliant but, you don't seem to know what a recession is.

"The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is 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. For more information, see the latest announcement on how the NBER's Business Cycle Dating Committee chooses turning points in the Economy and its latest memo, dated 07/17/03."

Economic activity is in significant decline.

Declines in real income (to include all US Americans) have been extraordinary since 1969 (when we first see an inflection in the income inequality graph). Present income inequality (a crucial measure of real relative income) has not been seen since prior to the Great Depression.

Unemployment has risen dramatically over 2008 (and we have lost more than 1.2 million jobs.)

Retail declined last month by the most on record (2.8%). Everybody's been lowering their guidance for ages and, my understanding is that not it's just about impossible to get credit to stock the shelves at some stores.

The housing market, moreover, is a disaster and a half. [CNN and CNBC regularly indicate that it is unrivaled (again) since the Great Depression.]

And, that's just the tip of the iceberg (the bulk of an iceberg is floating under water, by the way).

If you so choose, you can verify all this (and discover much more) at the NBER and a site such as Bloomberg.

You may also find this CFR interview with cofounder and managing director of the Carlyle Group enlightening, Grasping Radical Economic Change.

We are decidedly in recession according to the NBER definition. And things are still on a downward trajectory.