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Editor's Note: This column originally appeared on


Nov. 12

This is what I call a Rodney Dangerfield recovery -- it gets no respect. Plenty of people are convinced we're still in recession, somehow overlooking the fact that we've now had a full year of positive GDP growth averaging 3%.

And it's not just GDP. Industrial production, personal income, sales and employment are all above their lows. In other words, the economy's been in a recovery all year.

The reason why people are so skeptical about this simple fact has to do with stock prices, which have plunged viciously, contrary to the pattern in normal recoveries. But as a famous economist once observed, "The stock market has predicted nine of the last five recessions." Is this the 10th?

Recession-Proof or Recession-Prone?

The hallmark of the new century has turned out to be the rediscovery of risk -- with regard to both our physical and financial security. Risk had never really disappeared, but in retrospect, the 1990s look like a long, golden moment between the Cold War and the war on terror, when risk seemed to recede amid the rapid expansion of possibilities.

The apparent retreat of risk, including the risk of recession, was the key to the late 1990s boom. As

I noted last July, the late 1990s view that the risk of recession had virtually vanished implied that stocks were far less risky than previously believed, thus justifying much higher valuations. This was the sort of logic used to justify predictions of "



Amazingly, until late this past July, some top Washington officials and Wall Street bulls kept claiming we didn't have a real recession in 2001, until revised data showed that GDP had dropped not only in the third quarter of that year but also in the first and second quarters. At that point, they couldn't even blame the terrorists for the recession -- the misguided conclusion I

warned against after Sept. 11.

But in the "new era" of the 1990s and even through early 2002, too many people thought the economy was recession-proof and tried to value stocks accordingly. Since the bust, we've come full circle, and now too many believe that the economy is actually recession-prone, thus justifying far lower valuations. This creates a vicious cycle, in which plunging stock prices sap business and investor confidence, creating the danger of a self-fulfilling prophecy.

The central fear that has gained ground again is that of a double-dip recession, but its meaning has morphed. Early this year, proponents of this view were pointing out that most recessions in the past few decades had double dips: GDP growth often turned positive for a quarter or two in mid-recession before turning negative again. Thus, the GDP's upturn in the first quarter of 2002 would be followed by a renewed decline that would confirm the recession's persistence.

As is often the case with forecasts based on averages, this turned out to be a false alarm. GDP has now grown at a 3% rate for a full year, which simply doesn't happen in the middle of a recession. In line with my

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forecast, a gentle rebound began by the first quarter of the year and didn't give way to a renewed contraction in the second or third quarter.

The real question now should be, is a


recession imminent? The best way to answer the question is to look at the Economic Cycle Research Institute's leading indices, which correctly

predicted the 2001 recession.

A Window of Vulnerability?

After rising through mid-2002, ECRI's leading indices have begun to falter. This is true of the Weekly Leading Index as well as the Short Leading Index and, to a lesser extent, of the Long Leading Index. But as of yet, none of the indices shows recessionary declines.

This becomes quite clear from a chart of WLI growth. Sure, it has dropped, but no more than in 1998, when a recession was averted. The problem is that a window of vulnerability has begun to open, unlike the situation earlier this year.

WeeklyLeading Index, Growth Rate (%)
Shaded areas represent U.S. businesscycle recessions

Source: ECRI

The crux of the problem is business confidence, which has been slammed by the stock market slide. Even as consumers have kept spending, businesses have dragged their feet on hiring.

Will the events of early November, including the Republican sweep of Congress, the U.N. resolution on Iraq and the


rate cut, be enough to start restoring business confidence? Or will the uncertainties about a war in Iraq trigger a significant increase in job cuts, damaging not just consumer confidence but also spending?

If it turns out to be the latter, ECRI's leading indices are likely to fall further, signaling a new recession. That would be doubly dangerous for stock prices, because it would hurt both earnings expectations and valuations, as the notion of a risky, recession-prone economy gets underscored.

The Giant Error of Pessimism

The event risk reflected in stock prices comes on top of a more basic pessimism typical of the bust that follows a boom. My mentor and ECRI founder Geoffrey H. Moore was mentored by legendary business-cycle researcher Wesley C. Mitchell, who was all too familiar with the sort of boom-bust cycle we've recently witnessed for the first time since World War II ended. Writing 75 years ago, Mitchell noted the "error of optimism" that arises during a boom:

"The optimistic error once born grows in scope and magnitude ... But since the prosperity has been built largely upon error, a day of reckoning must come. This day does not dawn until after a time long enough to construct new industrial equipment to market, and to find that they cannot be disposed of promptly at profitable prices. Then the past miscalculation becomes patent to creditors as well as to debtors, and the creditors apply pressure for repayment. Thus prosperity ends in a crisis."

Once the cycle turns down, unquestioning faith is broken and pessimism runs rampant. Or, as Mitchell writes, citing Arthur C. Pigou's words from 1920:

"The error of optimism dies in the crisis but in dying it 'gives birth to an error of pessimism. This new error is born, not an infant, but a giant; for an industrial boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence.'"

This giant error of pessimism is now on the loose and is no less dangerous for being an error. By predisposing business decision-makers toward distrust, it could increase the economy's vulnerability to external shocks.

However, the weakness in ECRI's leading indices is still consistent with a continued recovery, but one that's even more anemic than what we've experienced. Yet if business pessimism begins to dissipate in the weeks ahead, the outlook for next year will turn decidedly brighter.

Anirvan Banerji is the director of research for the

Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at

Anirvan Banerji.