Recession? Stagflation? Depends on the Definition

One of the most remarkable developments that few seem to appreciate is that the U.S. business cycle has become flatter and longer. There may be numerous contributing factors, such as better inventory management, flexibility of the capital markets and the increasing importance of the service sector . The U.S. economy has experienced five quarters of negative growth in the past 17 years, and seven quarters of negative growth in the past quarter-century.

There are two main culprits the market often cites as causes for economic downturns. First are external developments, such as the oil shocks in the 1970s or the first Gulf War in the early 1990s. The second is the Federal Reserve . Both seem exaggerated.

Sure, external variables can tip the economy over, but only, it seems, if it is already vulnerable. Look at the oil shock of recent years. Pundits have proclaimed every $10-a-barrel increase over $40 economically intolerable. But if the U.S. economy expanded by 1.5% in the fourth quarter of 2007, which seems like a reasonable conservative estimate, that would place second-half growth in 2007 at an impressive 3.2% pace, a pace that most industrialized countries would envy.

The Federal Reserve is also often cited, especially in some political quarters, as responsible for economic downturns by setting monetary policy too tight for too long. When he was much younger and under the influence of Ayn Rand, former Federal Reserve Chairman Alan Greenspan seemed sympathetic to such a view.

Yet the historical record suggests otherwise. That is to say the business cycle existed long before the Federal Reserve was created in 1913. As noted above, the amplitude of the business cycle has been reduced, and the durations of the business cycle have increased.

This raises the issue of the business cycle itself.

There is one camp that argues that the seeds for an economic downturn are planted during the expansionary phase. Another camp says that the end of the business cycle is due to factors outside the business cycle. There has been much ink spilled in defense and criticism of each camp. Suffice it to say that business cycles are like people -- they can die of old age and not just be murdered.

The issue of defining a recession is not simply academic -- there are important policy and investment implications. For example, over the last several cycles, it has taken the real fed funds rate (fed funds adjusted for inflation) near zero to reinvigorate the economy. Also, past economic downturns often have led to fiscal stimulus, beyond the usual countercyclical spending, like unemployment compensation.