Financial & Economic Crisis

Recession: History and Theory

A recession is a contraction phase of the business cycle, or "a period of reduced economic activity." The U.S. based National Bureau of Economic Research (NBER) defines a recession more broadly 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." A sustained recession may become a depression.

Some business and investment glossaries add to the general definition a rule of thumb that recessions are often indicated by two consecutive quarters of negative growth or contraction of gross domestic product (GDP). Newspapers often quote this rule of thumb, however the measure fails to register several official US recessions.

A recession has many attributes that can occur simultaneously and can include declines in coincident measures of overall economic activity such as employment, investment, and corporate profits. Recessions are the result of falling demand and may be associated with falling prices (deflation), or sharply rising prices (inflation) or a combination of rising prices and stagnant economic growth (stagflation). A severe or prolonged recession is referred to as an economic depression. Although the distinction between a recession and a depression is not clearly defined, it is often said that a decline in GDP of more than 10% constitutes a depression. A devastating breakdown of an economy essentially, a severe depression, or hyperinflation, depending on the circumstances is called economic collapse.

Predictors of a recession

There are no completely reliable predictors. The ones discussed below are regarded to be possible predictors.

In the U.S. a significant stock market drop has often preceded the beginning of a recession. However about half of the declines of 10% or more since 1946 have not been followed by recessions. In about 50% of the cases a significant stock market decline came only after the recessions had already begun.

Inverted yield curve, the model developed by Fed economist Jonathan Wright, uses yields on 10-year and three-month Treasury securities as well as the Fed's overnight funds rate. Another model developed by Federal Reserve Bank of New York economists uses only the 10-year/three-month spread. It is, however, not a definite indicator; it is sometimes followed by a recession 6 to 18 months later.

The three-month change in the unemployment rate and initial jobless claims. Index of Leading (Economic) Indicators which includes some of the above indicators.

Responses to a recession

Strategies for moving an economy out of a recession vary depending on which economic school the policymakers belong to. While Keynesian economists may advocate deficit spending by the government to spark economic growth, supply-side economists may suggest tax cuts to promote business capital investment. Laissez-faire economists may simply recommend the government remain "hands off" and not interfere with natural market forces. Populist economists may suggest that benefits for consumers, in the form of subsidies or lower-bracket tax reductions are more effective, and serve a double purpose including relieving the suffering caused by a recession.

Both government and business have responses to recessions. In the Philadelphia Business Journal, Strategic Business adviser Carter Schelling discussed precautions businesses take to prepare for looming recession, likening it to fire drill. First, he suggests that business owners gauge customers' ability to resist recession and redesign customer offerings accordingly. He goes on to suggest they use lean principles, replace unhappy workers with those more motivated, eager and highly competitive. "Companies," he says, "get better at what they do during bad times." He calls his program the "Recession Drill."

Central bank response

This article or section deals primarily with the United States and does not represent a worldwide view of the subject.

Usually, central banks respond to recessions by easing monetary conditions, e.g. lowering interest rates. In the United States, the Federal Reserve has responded to potential slow downs by lowering the target Federal funds rate during recessions and other periods of lower growth. In fact, the Federal Reserve's lowering has even predated recent recessions. The charts below show the impact on the S&P500 and short and long term interest rates.

July 13, 1990 - September 4, 1992: 8.00% to 3.00% (Includes 1990-1991 recession)

February 1, 1995 - November 17, 1998: 6.00% to 4.75%

May 16, 2000 - June 25, 2003: 6.50% to 1.00% (Includes 2001 recession)

June 29, 2006 - October 8, 2008: 5.25% to 1.50%

Siegel points out that cuts in the Federal funds rate are now widely anticipated; therefore, cuts are no longer followed by a longer-term rise in stock market indexes.

The declining frequency of recessions in the past two decades and the reduction in GDP declines suggest that the Federal Reserve has been successful in moderating contractions. However some critics argue that reducing the Federal funds rate has had the effect of adding too much liquidity to the financial markets and excess debt accumulation by consumers. Empirical research by the staff of European Central Bank showed a correlation between excessive money growth and the depth of post-boom recessions.

Relationship between recessions and stock market

This article or section deals primarily with the United States and does not represent a worldwide view of the subject.

Some recessions have been anticipated by stock market declines. In Stocks for the Long Run, Siegel mentions that since 1948, ten recessions were preceded by a stock market decline, by a lead time of 0 to 13 months with the average of 5.7 months. It should be noted that ten stock market declines of greater than 10% in the DJIA were not followed by a recession.

The real-estate market also usually weakens before a recession. However real-estate declines can last much longer than recessions.

Since the business cycle is very hard to predict, Siegel argues that it is not possible to take advantage of economic cycles for timing investments. Even the National Bureau of Economic Research (NBER) takes a few months to determine if a peak or trough has occurred in the US.

During an economic decline, high yield stocks such as financial services, pharmaceuticals, and tobacco tend to hold up better. However when the economy starts to recover and the bottom of the market has passed, growth stocks tend to recover faster. There is significant disagreement about how health care and utilities tend to recover. Diversifying one's portfolio into international stocks may provide some safety; however, economies that are closely correlated with that of the U.S.A. may also be affected by a recession in the U.S.A.

Political implications of recessions

Generally an administration gets credit or blame for the state of economy during its time. This has caused disagreements about when a recession actually started. In an economic cycle, a downturn can be considered a consequence of an expansion reaching an unsustainable state, and is corrected by a brief decline. Thus it is not easy to isolate the causes of specific phases of the cycle.

The 1981 recession is thought to have been caused by the tight-money policy adopted by Paul Volcker, chairman of the Federal Reserve Board, before Ronald Reagan took office. Reagan supported that policy. Economist Walter Heller, chairman of the Council of Economic Advisers in the 1960s, said that "I call it a Reagan-Volcker-Carter recession. The resulting taming of inflation did, however, set the stage for a robust growth period during Reagan's administration.

It is generally assumed that government activity has some influence over the presence or degree of a recession. Economists usually teach that to some degree recession is unavoidable, and its causes are not well understood. Consequently, modern government administrations attempt to take steps, also not agreed upon, to soften a recession. They are often unsuccessful, at least at preventing a recession, and it is difficult to establish whether they actually made it less severe or longer lasting.

Understanding of the word "recession" differs between economists, newspapers, and the general public. Generally speaking, a recession is present when graphs are sloping down in respect to production and employment. Consequently, a politician can truthfully say "the recession is over," even though little has improved. This may imply to the public that the economy is in recovery, suggesting the graphs are sloping upward, though there may actually exist a period of stagnation, when numbers remain low even though they are no longer dropping.

United States recessions

According to economists, since 1854, the U.S.A. has encountered 32 cycles of expansions and contractions, with an average of 17 months of contraction and 38 months of expansion. However, since 1980 there have been only eight periods of negative economic growth over one fiscal quarter or more, and three periods considered recessions:

January-July 1980 and July 1981-November 1982: 2 years total duration;

July 1990-March 1991: 8 months duration;

November 2001-November 2002: 12 months duration.

Between 1991 and 2000, the U.S. experienced 37 quarters of economic expansion, the longest period of expansion on record.

For the past three recessions, the NBER decision has approximately conformed with the definition involving two consecutive quarters of decline. However the 2001 recession did not involve two consecutive quarters of decline, it was preceded by two quarters of alternating decline and weak growth.

Global recessions

There is no commonly accepted definition of a global recession. The IMF estimates that global recessions seem to occur over a cycle lasting between 8 and 10 years. During what the IMF terms the past three global recessions of the last three decades, global per capita output growth was zero or negative.

Economists at the International Monetary Fund (IMF) state that a global recession would take a slowdown in global growth to three percent or less. By this measure, three periods since 1985 qualify to be global recessions: 1990-1993, 1998 and 2001-2002.

2008 recession

Since 2007, there had been speculation of a possible recession starting in late 2007 or early 2008 in some countries.

In January 2008, the IMF predicted that 2008 global growth would fall from 4.9 percent to 4.0 percent as measured in terms of purchasing power parity, however 2 months later it was announced that this projection was not low enough.

There was significant speculation about a possible U.S. recession in 2008. If such a recession happened, it was expected to have a global impact. The U.S. represents about 21 percent of the global economy, and impact of a U.S. recession might include the following effects:

- Less spending by American consumers and companies reduces demand for imports.

- The crisis of the U.S. sub-prime-mortgage market has pushed up credit costs worldwide and forced European and Asian banks to write down billions of dollars in holdings.

- Dropping U.S. stock prices drag down markets elsewhere.

The United States housing market correction, a consequence of United States housing bubble, as well as sub-prime mortgage crisis had significantly contributed to anticipation of a possible recession.

U.S. employers shed 63,000 jobs in February 2008, the most in five years. Former Federal Reserve chairman Alan Greenspan said on April 6, 2008 that "There is more than a 50 percent chance the United States could go into recession". On October 1st, the Bureau of Economic Analysis reported that an additional 156,000 jobs had been lost in September. On April 29, 2008, nine US states were declared by Moody’s to be in a recession.

Although the US Economy grew in the first quarter by 1%, by June 2008 some analysts stated that due to a protracted credit crisis and "rampant inflation in commodities such as oil, food and steel", the country was nonetheless in a recession. The third quarter of 2008 brought on a GDP retraction of .03% - the biggest decline since 2001. The 6.4% decline in spending during Q3 on non-durable goods, like clothing and food, was the largest since 1950.

A few other countries have seen the rate of growth of GDP decrease, generally attributed to reduced liquidity, price inflation in food and energy sectors, and the US slowdown. These include the United Kingdom, Japan, China, India, New Zealand and the eurozone countries.

Recessions have a large impact on economies including such effects as bankruptcies, deflation, foreclosures, reduced sales, stock market crashes, unemployment and banks lending less money.

 

 
This article uses material from the Wikipedia article "Recession"

 

 

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