This Recession Didn't Have to Happen

The U.S. economy is now locked on a recession track. Yet this is a recession that didn't have to happen.

An unusual feature of this recession is that pundits have been predicting it for years (never mind that they kept being wrong for years), because what are typically considered recessionary shocks, such as Fed rate hikes, oil price spikes and a major housing downturn, had already arrived by 2005. By early 2007, the pessimism had mounted, with markets expecting multiple Fed rate cuts to avert a recession.

What we got instead was acceleration in GDP growth to a four-year high, following a surge in the growth rate of the Economic Cycle Research Institute's weekly leading index (WLI) to a three-year high.

Bernanke Botched It, Says Critic

Partly because of the prolonged pessimism about U.S. economic growth, the dollar plunged against the euro -- no matter that in 2007 GDP grew at a 2.5% pace in the U.S., compared with only 2.3% in the euro zone. The weaker dollar made U.S. exports much more competitive, bolstering U.S. exports and supporting the U.S. manufacturing sector, making it harder for the economy to slip into recession.

Meanwhile, the pessimism had spread to CEOs, who aggressively pared down inventories, bringing the inventory-to-sales ratio down to a record low. This presented a unique opportunity for policy stimulus to avert a recession -- an opportunity that was missed. How could that be?

The Hallmarks of a Recession

Let's understand what happens in a typical recession. Normally, going into a recession, business managers have little clue that a recession is about to hit, and they plan their production on the basis of the assumption of steadily rising demand.

Therefore, when demand for their products suddenly falls apart because of the recession, they get stuck with rapidly rising inventories and are forced to slash production and jobs, thereby reducing income and spending in the economy. This in turn feeds back into lower sales for a variety of industries, and that triggers further production cutbacks, perpetuating the vicious cycle that is the hallmark of recession.

If you examine the contribution of each major sector of the economy in all the slowdowns and recessions we've experienced since the mid-1960s (see chart), you'll see that in every single recession, it was the manufacturing sector that accounted for more than half the downward impetus, even though it's the smaller part of the economy. This is largely because of the inventory cycle, which helps make manufacturing so volatile.

Click here for larger image.

A Unique Opportunity

But this time, the rise in inventories that's typical in the lead-up to a recession was absent. Rather, premature pessimism about the economy had induced businesses to cut inventories to the bone.