Recessions often begin before the thing that caused them occurs
By Scott Sumner
I hope the title of this post has caught your attention—if not please reread it.
In the previous few recessions, the consensus of economists did not even forecast a recession until it was already underway. That is, not only can economists not forecast the economy, they can’t even “nowcast” the economy.
One reason for this is that the early stages of a recession are often quite mild. In July 2001 the unemployment rate was only 4.6%, up from 4.3% in March, when the recession began. In April 2008 the unemployment rate was 5.0%, the same as in December 2007, when the recession began. Yes, unemployment can be a lagging indicator, but other monthly indicators were also relatively stable during the early months of each recession.
The title of the post relates to a strange quirk in the definition and dating of recessions. Not all fluctuations in the economy are regarded as recessions, just large ones. But the recession is assumed to begin when the data first starts dropping, even if the initial drop was too small to constitute a recession. It’s contingent on what happens later. Thus if the Fed had done massive monetary stimulus in July 2001, or April 2008, and the economy had grown strongly, then there would have been no recession. And yet that stimulus would not have even occurred until 4 months after the recession began! If (like me) you believe the recession was caused by tight money (or lack of monetary stimulus if you prefer that language), then the recessions of 2001 and 2008 began before the event that caused them.
Here’s an analogy. A bus normally drives down the center of the lane. Every so often it veers 3 feet to the right or left, due to inattention by the driver. Then the driver corrects. But one time after the bus veers 3 feet to the right, the driver is distracted by his cell phone ringing. The driver does not take the normal corrective action. Now the bus continues to veer off the road, into an accident. The key factor that caused the accident was the driver being distracted by the cellphone, but the beginning of the accident would be defined as the time the bus started to veer off course, if the NBER was doing the accident investigation.
Commenter BC asked me this very interesting question:
If recessions are caused by declines in NGDP and if we believe that NGDP futures markets are good at predicting changes in NGDP, then doesn’t that mean that recessions are predictable, at least by NGDP futures markets participants? I can understand why EMH implies that it should be difficult *to profit* from knowledge of an impending recession, but I don’t see why recessions should necessarily be unpredictable.
Conversely, if recessions are unpredictable, then does that imply that central banks always or almost always do a good job: they rarely have reason to believe that their policies will do anything other than to maintain stable NGDP? For example, when the ECB raised rates in 2011, was it predictable or unpredictable that such policy would cause a double-dip recession. If unpredictable, then was the rate increase the right (a priori) policy, the policy that would make future NGDP just as likely to be above target as below target, given information available at the time?
I hope you can see how the previous analysis relates to this question. Here was my response:
BC, That’s actually a very good question, and the answer is very complicated. My view is that a NGDP futures market would not have been able to predict the 2008 recession until is was underway, but none the less would have been able to prevent it, or at least make it milder. Here’s a possible sequence:
Late 2007, NGDP futures market would have predicted slowdown in 2008, but no recession. Had we been following NGDPLT, then monetary policy would have been made more expansionary at that time.
Then the slowdown occurred. During the second half of 2008, an NGDP futures market would have been predicting that the slowdown would turn into an outright recession. Notice that this is a successful prediction of a worsening of the recession, but it doesn’t count as predicting a recession because the recession actually began in December 2007.
Here’s a driving analogy. I can predict when the steering of the bus will lead it to drift off the center of the lane, but not when the bus will veer off the road and crash. If I nudge the bus back to the center each time it begins to veer off, then the bus never crashes.
An NGDP futures market cannot predict when the central bank will take the necessary nudges to keep NGDP track, but it can actually help the central bank do those nudges if it wants to.
As Jim Hamilton once pointed out, it would be a bad sign if the central bank could predict recessions:
You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.
After all, if you could predict it, why wouldn’t you prevent it? (At least for demand side recessions. Supply shocks are also hard to predict.)
As far as the 2011 double dip, my view is that futures markets might have missed the recession prediction at the time. But the policy was still a mistake because the eurozone economy was quite weak at the time, it was already skirting on the right edge of the highway. An NGDP futures market would have told the ECB to do a more expansionary policy.