Why is there a recession debate? Is there even a recession?

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In their fifth edition of Macroeconomics, R. Glenn Hubbard and Anthony Patrick O’Brien tried to warn us.

“Although writers for newspapers and magazines often define a recession as two consecutive quarters of declining real GDP, the NBER has a broader definition: “A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.”

Hubbard, R. Glenn, and Anthony Patrick O’Brien. Macroeconomics, 5th Edition. Pearson, 2015.

Since the BEA’s release of second quarter US GDP critics, pundits, and talking heads have declared the start of a US recession. Predictably, White House pushback only added dry tinder to the smoldering dumpster fire known as the 24-hour news cycle. White House critics attacked the administration as trying to ‘rebrand’ or put some ‘spin’ on the bad economic news. These critics missed the fact that for just over a century, another organization, and not the White House, have been officially calling recessions in the US. Some critics confidently declare the definition of recession as “2 consecutive quarters of declining real GDP” (for brevity we’ll just gonna call this the 2 quarters rule of thumb- better yet let’s say ‘2QR’) as basic economics or as ‘economics 101’. If this knowledge is so basic how come so many have missed the mark? Before we answer that question however we think a quick review of the basics might be helpful.

 

First of all: WTF is a recession?

 

Here’s one definition of a recession from the 3rd edition of Cowen and Tabarrok’s Modern Principles: Macroeconomics (2015).

“a significant, widespread decline in real GDP and unemployment”

“Cowen, Tyler and Tabarrok, Alex. Modern Principles: Macroeconomics. Pearson, 2015.

 

If this sounds very vague and abstract, that’s because it is. Gross Domestic Product, or GDP, acts as a yardstick to measure economic activity.  While many parts of GDP are arbitrary, and the measure itself is full of flaws, we’ll leave that for another post. The most important takeaway is that GDP consists of four components. Here they are in order of relative portion of total GDP:

  • Consumption: Private spending on new goods and services. The most important part. Accounts for almost 70% of the US economy according to the St Louis Fed ¹.

  • Investment: the purchase of new housing, as well businesses’ purchase of capital goods (factories, commercial buildings), equipment, and inventory. About 18.7% of US GDP.

  • Government expenditure on goods and services: spending on goods and services made by local, state, and federal levels of government. 17.3% of GDP

  • Net Exports: goods sold abroad (exported) subtracted by goods purchased from abroad (imported). -4.4% of GDP. Negative because the US economy imports more than it exports.

 

Q2 2022 GDP components by share of GDP

 

Interesting final point to note: as eminent Harvard economist N. Gregory Mankiw remarks in his best selling textbooks on economics, recessions are random, can range from a few months to a few years, and no two are quite the same.

 

 

The origin of the “2 quarters rule of thumb” and why so many are confidently incorrect about it

 

“I’ve heard that hard work never killed anyone, but I say why take the chance?”

Ronald Reagan, 40th US president

We can thank laziness and a misinterpretation of a 1974 New York Times OpEd written by Julius Shiskin. Though not a household name, Shiskin was a rockstar statistician who raised the profile of several of the departments he worked in and was also the pioneering Commissioner of the Bureau of Labor Statistics. In 1980 the American Statistical Association created an eponymous award recognizing Shiskin’s career contributions. According to his obituary in The American Statistician, Shiskin was a staff assistant at the NBER from 1928-1942. In his NY Times OpED Shiskin attempts to explain the NBER’s methodology (the 3 D’s – or depth, duration, and diffusion) for calling recessions into layman’s terms:

  1. Duration:
    • 2 consecutive quarters of decline in real GDP (Shiskin used GNP)
  2. Depth:
    • a 1.5% decline in real GDP
    • a decline in nonagricultural employment
    • a 2 percent jump in overall unemployment to at least 6%
  3. Diffusion:
    • an increase in nonagricultural unemployment in more than 75% of industries, for 6 months or longer

So while Shiskin’s ELI5 version of the NBER’s methodology for dating recessions was well intentioned, over time 2 of the 3 D’s faded away like a balding, middle-aged, economics teacher’s hairline. For some unexplained reason just the D representing duration stuck around, becoming the rule of thumb entirely.

 

So what’s the problem with the rule of thumb of 2 consecutive quarters of negative real GDP?

 

Because nobody knows the tools of recession dating better than the practitioner themselves, perhaps the faultiness of the 2QR should come from the chairman of the organization that actually calls US recessions (NBER). Robert Hall, Stanford economist and chairman of the NBER spoke with the Wall Street Journal’s Josh Mitchell and Harriet Torry. 2 Below is what he had to say about using 2 consecutive quarters of negative real GDP to date recessions.

“That’s not anything close to the philosophy the committee brings to identifying it. It really doesn’t make any sense.”

Robert Hall, chairman of NBER, speaking to Wall Street Journal reporters

The problem is the 2QR lacks flexibility. The NBER utilizes a more wholistic approach. Every recession is different in its dynamics and characteristics. Take the 2020 recession as an example. There’s little dispute that the economy experienced a recession in the first quarter of 2020. The problem with proponents of the 2 quarters rule of thumb is that the NBER released an announcement which dated the 2020 recession as the shortest on record, weighing in at only two months long. The bigger issue may lie in the use of GDP as a measuring tool in the first place.

What’s the problem with GDP?

 

GDP is a wrecking ball when a hammer will suffice. GDP is a blunt tool painfully lacking in precision.  Precision is a highly desired quality for tools which are utilized by an organization like the NBER. Dating recessions by getting economic data from GDP every 90 days is similar to stirring your morning coffee with a snow shovel rather than a teaspoon. Furthermore, the effect of an underperforming month can be masked by two over-performing months, and vice-versa. Because of the nature of its quarterly release, GDP is not of high value to politicians, academics, the media, and economists for dating recessions. GDP is a lagging indicator, meaning it is backwards looking so its useful only in confirming what has already transpired. For dating recessions, GDP is like the deployed airbag in a car collision: you already know something bag has happened when you see it. Anyone living through the first six months of 2020 was already well aware – and didn’t need an update from the BEA telling them – the US has dramatically plunged into a recession territory.

 

If GDP is so full of flaws does a better measure of timely economic activity exist?

 

Yes! In today’s world of instant gratification featuring theme park fast-passes, movies on demand, and same-day delivery few folks want to wait for quarterly GDP press releases. Even fewer people want to wait as long as 12 months for the NBER to date the start/end of a recession. One alternative measure is produced monthly by the Chicago Federal Reserve Bank. It’s based on research developed by James Stock and Mark Watson called Chicago Fed National Activity Index (CFNAI) which is a weighted index of 85 measures of economic activity based on four broad categories:

  1. production and income
  2. employment, unemployment, and hours
  3. personal consumption and housing
  4. sales, orders, and inventories

But wait there’s more! The St. Louis Federal Reserve Bank publishes a monthly recession possibilities model developed by Marcelle Chauvet based on 4 criteria:

  1. non-farm payroll employment
  2. the index of industrial production
  3. real personal income excluding transfer payments
  4. real manufacturing and trade sales

These two methods have a massive advantage over GDP in that they are released monthly and they have research supporting their accuracy in tracking the overall US economy. Common sense advice from another legend of a rockstar statistician:

“Without data, you’re just another person with an opinion”

W Edwards Deming

References:

  1. U.S. Bureau of Economic Analysis, Shares of gross domestic product: Personal consumption expenditures [DPCERE1Q156NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPCERE1Q156NBEA, August 29, 2022.
  2. Josh Mitchell and Harriet Torry. 2022. “What Is a Recession and Are We in One Now?” The Wall Street Journal, July 28, 2022. https://www.wsj.com/articles/what-is-a-recession-and-are-we-in-one-now-11655392738