Indicators of Economic Recession

Economists struggle to accurately define many things; recessions (as well as their causes and solutions) happen to be one of those things. The generally accepted definition of a recession in the field of formal, neoclassical microeconomics is the reduction, in terms of GDP, of a country’s production for two or more quarters. What indicators and metrics do economists use to predict recessions? What policy implications, economic problems, or global trends can be seen to effect recessions - perhaps even prevent them?

Many financial economists - particularly those involved in the strictly financial analysis and advisory fields - often offer an answer to the indicators of recession that lies entirely in the field of the stock market. They say in North American and chiefly Western societies, recessions can be predicted by sharp, unexpected falls in the average performance of the stock market; say measured by the Dow Jones, or Standards & Poor’s 500-index.

This definition is entirely insufficient. Any uneducated economic analyst can look at past large, unexpected falls in stock pricing and valuation, finding that dozens of the largest falls in the last 70 years have been followed by nothing that meets the definition (or even the colloquial appearance) of a recession. Furthermore, analysis of our current1 2007/8 recession, and in fact, the 4-or-so2 recessions in the last two decades do demonstrate a large stock index collapse - but, it’s been well after the recession clearly began. It’s safe to say a market collapse at some level is a recession symptom, but at the point in which it’s demonstrative, it’s no longer an indicator.

An inverted yield curve is perhaps the best measurable indicator of inbound recession - the point in which yields on long-term investments (specifically, those which mandate a holding period; such as a term deposit) fall below the yields on short-term deposits. This demonstrates the holistic ability of the market to identify itself, in that pricing and yields on such investments are determined by wholly supply-and-demand models. If the market knows that the value of money, or its ability to produce yield is going to fall in the future, borrowers are going to be less willing to borrow money at higher rates; more specifically though, the formulation of risk in to the calculation ensures that if the market perceives a decrease in expected monetary value, that will be included in the price (more clearly, the rate, or yield).

This method works in theory - the pricing of risk, knowledge about risk, and investors expectations in to the market determines the yield, and if the yield is reduced in the longer term, expectations of the economy in the same term should match accordingly - but, more importantly, experimental data suggests it works in reality as well. It will not be perfect - by design, it is imperfect; investors, borrowers, etc. (specifically individuals, but also the aggregate), do not have perfect knowledge about the entire market - and likely don’t make perfect economically rational decisions. That said, five of the six3 inverted yield curves in the last three decades have accurately predicted a weakening economic environment - that’s not to say a formal recession, per se.

Interestingly, this risk-pricing type theory of recessions correlates identically with the flight-to-quality. During a recession, as we see presently in December 2008, investors are incredibly risk-averse. Treasuries are currently paying almost no yields, yet, investors are selling off their higher risk investments and investing in what they perceive to be lower risk, more “quality” investments4.

Finally, a non-government organization, the Conference Board, publishes an index of Leading Economic Indicators thought to predict business cycles and other economic activity. The index contains 10 items, including many more subjective metrics in the way of consumer sentiment and worked hours; the index experimentally predicted every recession over the past 50 years, however, it predicted nearly 200% the number of economic withdrawals that actually occurred.

Investors should be warned - the difficulty of understanding and accurately predicting business cycles, looming recessions, and other potentially effective economic metrics makes using economic data to predict recessions with the intent of scraping rent profits from your investments victim to a particularly strong level of uncertainty. Most experts in the financial services markets would claim that knowledge in this area, at the current time, is useless with regard to investment. Causes of recession are still not well understood, though much in the way of prediction and indication is available, the knowledge is loose at best.

1 Our current recession is in fact, debatable in terms of meeting the neoclassical definition. We have not seen negative growth for two periods. Rather, we base this nomenclature on the United States’ National Bureau of Economic Research having classed our current period - in fact, since the end of 2007 - to be in “recession.”
2 For the simple matter of analysis, we’re considering only the early 2000s Dot-Com Bubble collapse, the early 1990s manufacturing collapse in the United States, and the 1981 oil crisis as being formal recessions.
3 The one in that sample set that was not immediately/accurately followed by weakening economic conditions, was seemingly predicative of such a situation six months later.
4 Quality is in quotations here, the reason is simply that not all economists agree with regard to Treasuries.


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