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
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
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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.
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.
Make no mistake -- this is what created a unique opportunity for prompt fiscal and monetary policy action to avert this recession. As this year began, prompt stimulus to boost consumer spending could have made a decisive difference, and policy makers seemed to understand. The administration and Congress passed a tax rebate package with unusual speed, as leaders correctly noted that "time is of the essence."
If the money had reached consumers in weeks instead of several months, the boost to consumer spending would have sent manufacturers scrambling to ramp up production instead of reducing inventories, and they wouldn't have been able to get the goods from China on such short notice. That's why prompt stimulus could have been unusually potent this time. Keeping the economy out of recession for the time being would have helped to stabilize the housing market (because in a recession, job losses make foreclosures mount) and bought some time to unfreeze the financial markets.
But policy makers may not have understood the importance of the timing of stimulus, since they were content to let the rebates start reaching consumers several months later, rather than demanding innovative ways to let stimulus reach consumers much sooner, as was needed. I don't know whether it was bureaucratic compulsion to adhere to business as usual or ideological considerations that impeded this effort to get money to consumers right away. But it's as if the medics had arrived and taken a quick decision to administer CPR ... in a few months!
For the purpose of averting a recession, several months is a lifetime -- after all, the last two recessions lasted just eight months each. So, despite a unique opportunity, fiscal stimulus is likely to arrive too late to avert a recession.
Only this month, the Fed has finally begun to take aggressive and unorthodox steps to stabilize the housing and credit markets. While such actions met the need of the hour, they're unlikely to have the same impact today that they would have had a few months ago.
Already, before last Christmas, WLI growth had plunged to its lowest reading since the 2001 recession. Yet ECRI held off on its recession call, because objectively, there was this unusual chance to head off a recession.
The Crashing Column
Envision a large Roman stone column that has just started to topple. As the fall begins, a modest push back would be enough to right it again. But if its fall gains momentum, it is virtually impossible to stop it from crashing down. That's what has now happened. Indeed, the process of spreading weakness that leads to recessionary job losses is now under way, and it is too late to head off the recession.
We know this because WLI growth has now plunged to its worst readings in nearly three decades, barring the immediate aftermath of the 9/11 attacks. More importantly, the weakness has now spread to the ECRI's leading index for nonfinancial services, a sector that accounts for five out of eight U.S. jobs. Even if the downturn in manufacturing, which accounts for one in 10 U.S. jobs, is modest, we are likely to see sustained job losses.
It's a somewhat different story with regard to GDP, because cyclically volatile manufacturing still accounts for 36% of GDP. A mild downturn in that sector should limit the decline in GDP in this recession.
In fact, we may or may not see two straight down quarters of GDP in this recession. But, contrary to popular belief, that's neither a necessary nor a sufficient condition for a recession. Please recall that the 2001 and 1960-61 recessions did not meet that criterion but still saw major job losses.
Some will rightly argue that recessions are cathartic and that to try and avert a recession with stimulus would be tantamount to rewarding the bad behavior of those who are contributing to the housing and credit bubbles. Perhaps, but we must also recognize that recessions bring with them collateral damage affecting millions of innocent bystanders.
The bottom line is that the outcome was not preordained. Because policy makers had a choice about the speed with which stimulus took effect, this recession was not inevitable until recently. In that sense, it's a recession of choice.
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 serves on the economic advisory panel for New York City, is the co-author of
Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy
and is the president of the Forecasters Club of New York. 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 appreciates your feedback;
to send him an email.
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