Recession: What is it and How did we get there?

Second quarter 2008

First of all, it hasn't yet been determined that the United States is currently in a recession. The National Bureau of Economic Research, the major (and supposedly unbiased) research organization amongst economists, has a special committee that examines economic data and decides if the U.S. economy is expanding or contracting. This determination is called the business cycle, and a contraction of the overall economy is called a recession.

The NBER defines a recession as a "significant decline in economic activity spread across the economy, lasting more than a few months." (For some historical fun, see their excellent table of economic contractions and expansions, dating back to 1854, at http://www.nber.org/cycles.html.)

This definition of a recession--a significant decline in economic activity, across the entire economy and lasting longer than several months--means that a determination can only be made in the future, after the data have been gathered and examined. In 2001, for example, it wasn't "officially" decided that the U.S. was in a recession until eight months after the fact. Therefore, many of the TV news talking heads discussing the "current recession" are bandying words without real meaning.

On May 8, Martin Feldstein, the head of NBER, commented in a Bloomberg TV interview that he believes the U.S. economy is "sliding into" a recession. It's certainly possible that he is correct. It's also possible that Krishna Guha of the U.K.-based Financial Times is correct, forecasting the U.S. will skirt a recession but not actually fall into one. The unfortunate fact remains that, even if this is not "officially" a recession, in some ways it's starting to feel, and behave, rather like one. However, the data are not yet complete and therefore the determination cannot yet be made.

The numbers

No one will argue that the U.S. economy has slowed in recent months. In April 2008, industrial production dropped--but only after it rose slightly in March. (See the website of the Federal Reserve Statistical Releases at http://www.federalreserve.gov/releases/G17/Current/default.htm.) Much of this drop was due to the automotive industry, which was hit with strikes and strike-related parts shortages since February 26, forcing GM and other vehicle manufacturers to temporarily close or cut production at more than 30 facilities.

The latest figures on personal income, as measured by the Bureau of Economic Analysis of the U.S. Department of Commerce, show an increase of 0.3% in March following a rise of 0.5% in February. (See http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm.) However, the Consumer Price Index, the most common measure of inflation as tracked by the Bureau of Labor Statistics at the U.S. Department of Labor, rose 0.6% in April, meaning that prices rose twice as fast as income. (Not good news. See http://www.bls.gov/news.release/cpi.nr0.htm.) These figures are not seasonally adjusted; they reflect the prices currently being charged in retail stores, whether or not they generally rise at any given time of year and then fall again after a certain season.

The unemployment rate, also tracked by the Bureau of Labor Statistics, was 5% in April, little changed from March. (See http://www.bls.gov/news.release/empsit.nr0.htm.) Layoffs in the fields of construction, manufacturing, and retail were offset by new jobs in health care and professional and technical services. While this doesn't help the people who lost their jobs, it shows the labor market is remaining roughly stable overall.

The most comprehensive measurement of economic activity is gross domestic product, or GDP, which combines all of the data into one number that supposedly reflects the rate at which the U.S. economy is contracting or expanding. In the fourth quarter of 2007, GDP growth was 0.6%; in the first quarter of 2008, it is estimated to have been 0.9%, an upward revision from the original estimate of 0.6% made in April. (All of the data for 1Q2008 are not yet in, so this estimate may change again before being finalized on June 26. See the Bureau of Economic Analysis' press release, dated May 29, at http://www.bea.gov/newsreleases/national/gdp/2008/pdf/gdp108p_fax.pdf.)

To put all this another way, the U.S. economy is 2.6% bigger in April of 2008 than it was in April of 2007. That's not a lot of growth (GDP reached 7.2% in 1984, for example) and perhaps it's not enough growth to maintain forward economic momentum (as a rule of thumb, it requires GDP growth of 3% to prevent unemployment from rising). But the fact remains that these GDP measurements are positive numbers, showing that while growth in the U.S. economy has slowed, it has not stopped nor retracted.

Causes

Charles Wheelan, author of the excellent primer Naked Economics: Undressing the Dismal Science (W.W. Norton, 2002) and an online financial expert for Yahoo (http://finance.yahoo.com/expert/archive/economist/charles-wheelan/1), comments that recessions are rather like wars: we'd prevent them if we knew how, but because each situation is different, the experts aren't entirely certain how to do that. (He also points out that the experts may have prevented any number of recessions in the past, but the general public only finds out about the times they fail.)

Most recessions happen when the economy is hit with a sudden shock, such as high oil prices (the 1970s), or a collapse in the stock market (1929) or technology equities (2001). The 9/11 terrorist attacks on the U.S. prolonged the 2001 recession, discouraging people from flying and causing layoffs in the airline and aircraft construction industries. Other recessions have been deliberately engineered by the Federal Reserve (1990) as a means of slowing the economy to curtail spiraling inflation.

U.S. recessions since World War II have been minor, historically speaking. The recession of 1973-75, for example, caused by a 300% rise in the price of crude oil, saw a fall in GDP growth of 3.4%; during the Great Depression of 1929-33 it dropped somewhere around 30%. This improvement in business cycling can be linked to improvements in monetary policy, as applied by the Federal Reserve, as well as to increased technology and worker productivity. Simply put, because the U.S. is so productive and its economy so massive (in raw figures, GDP was more than $14.8 trillion in 2007, as opposed to $103 billion in 1929, according to the U.S. Department of Commerce), it has become economically resilient; recessions don't seem to strike so deeply nor for such long periods of time.

The current slowdown

The primary cause of the current economic slowdown was the subprime mortgage crisis. In simple terms, a bunch of people bought more house than they could afford and financed their purchases with adjustable rate mortgages at an initially low interest rate. Most of these people intended to refinance their loans at a fixed rate of interest at a later date; the important thing at the time was to secure the property and gain wealth from the rising real estate market. After all, house prices always go up, don't they?

Just as responsible for the crisis were the mortgage companies that obtained the loans for these buyers. The agents for these companies ignored dicey credit reports and already overextended incomes, and wrote mortgages with adjustable rates with the full knowledge that, when interest rates rose, these buyers would not be able to meet their payments. Again, the expectation was for such subprime buyers to refinance later at a fixed interest rate, based upon their months of on-time payments and their accrued equity. After all, house prices always go up, don't they?

Unfortunately, as many of these buyers discovered, real estate values can fall as quickly as they can rise; in some overpriced markets, particularly in parts of Florida, California, and northern Virginia, subprime homeowners wound up owing more money on their mortgages than their houses were worth. With interest rates rising and house prices falling, many buyers were unable to refinance their mortgages and equally unable to meet their now-increased monthly payments. Foreclosures began, increasing the inventory of homes for sale and lowering house prices further, which raised the number of mortgages that cost more than the house was worth, which raised the number of defaulters and foreclosures, et cetera, ad nauseam.

Meanwhile, these subprime mortgages had been bundled together and sold to banks, hedge funds, and other financial institutions around the world. As homeowners ceased making monthly payments and foreclosures began, these banks were left holding worthless mortgages and owning houses that were falling in value so fast that even the experts can't tell how much they're truly worth. The situation was made worse by the fact that, of those bundled pools of subprime mortgages, no one knows how many buyers will continue to make payments on their homes and how many will walk away. This crisis and uncertainty have devalued the assets of banks around the world to the tune of hundreds of billions of dollars, forcing them to seek new injections of capital or face regulatory action when they cannot meet funding requirements.

So the current slowdown in the U.S. economy was started by the bursting of a housing bubble in overpriced markets, which has contributed to lowering residential real estate values across most of the country. The slowdown has been fueled, pun intended, by surging energy prices, caused by inadequate production in oil-producing nations, supply interruptions in politically unstable areas, increased energy demand across the globe, and speculators bidding up commodities prices for personal and corporate gain. (Because many commodities, including crude oil, are priced in U.S. dollars, when the U.S. economy and consequently its currency weakens, prices of commodities tend to rise to compensate.)

Higher fuel prices are feeding through the manufacturing pipeline to consumers in the form of higher prices for finished products, including food, clothing, pharmaceuticals, and furniture. (See the details of the April 2008 Producer Price Index, a measure of corporate inflation, at http://www.bls.gov/news.release/ppi.nr0.htm.) Many of these higher producer prices will find their way through to consumers via the Consumer Price Index, as previously discussed.

Global interactions

Decreased assets and falling profits are serious concerns for banks. With so much liquidity lost, if they don't have money available, they can't lend money out, and it's through writing loans and collecting interest that banks fuel economic growth, not only in the U.S. but around the world.

Because those pooled subprime mortgages were sold to global financial institutions, banks in the U.K., Switzerland, and the Eurozone are also suffering massive asset writedowns and these economies are slowing, too. House prices and consumer confidence in the U.K. are also falling. Industrial production in Canada has slowed because imports into the U.S. have decreased. Retail sales in Germany declined 1.7% in April and 2.2% in March. The Bank of England and the Reserve Bank of Canada have both lowered interest rates to support their flagging economies.

No one knows how the subprime mortgage crisis will play out; this is uncharted financial territory. However, the Federal Reserve, in cooperation with reserve banks in other nations including the U.K., the Eurozone, and Switzerland, has taken some creative measures to combat the effects of the crisis. These measures include increasing the money supply available to banks, making loans to financial institutions other than banks, and accepting a wider variety of collateral for loans. The collapse of Bear Stearns, caused by massive withdrawals by investors spurred on by a self-fulfilling rumor the company was failing, made a bailout necessary but seems to have renewed the confidence of many investors and financial institutions. These actions were recognized by the International Monetary Fund's Jaime Caruana in a report dated April 2008 (posted at http://www.imf.org/external/np/exr/key/finstab.htm under the title "Financial Markets Remain under Stress") and seem to be giving some traction to the recovery process, judging by recent U.S. economic data.

Summary

Is this economic slowdown truly a recession? We don't know yet.

Does it feel like a recession? In some parts of the U.S. and for those people who have lost their jobs or their homes, most certainly.

Is it over yet? Well, the housing market correction hasn't bottomed out yet. Prices are still falling in many parts of the country, and because banks are unwilling to write mortgages for borderline buyers, home sales are not expected to recover for the remainder of 2008. But other data in recent months have not fallen as far as expected or have measured improvements, further evidence of the massive resiliency of the U.S. economy.

UPDATE 02/20/2009

The data are in. Yes, we are in a recession and it's a nasty one. As soon as I have time, I'll write a new economic assessment of the U.S. from current fundamental data.