INSIGHTS: THE 2020 (US) RECESSION
Guest Columnist: Antonio Fatas, the Portuguese Council Chaired Professor of Economics at INSEAD, a Senior Policy Scholar at the McDonough School of Business at Georgetown University, and a Research Fellow at the Center for Economic Policy Research in London. Reprinted with permission.
A few months away from the longest US expansion
The US economy is a few months short of beating the longest expansion ever, which took place from March 1991 to March 2001. As we approach this milestone, there are increasing concerns about the possibility of a recession in the coming years.
Do expansions die of old age? The empirical evidence suggests that this is not the case. There is no clear correlation between the length of an expansion and the probability of a recession (Rudebusch (2016)).
An alternative definition of age
There is an alternative way of thinking about the age of an expansion, in terms of how much economic slack there is left. Expansions are periods where the economy is returning to full employment. As unemployment becomes low and reaches levels around or below the natural rate of unemployment, is it possible to maintain this state for a number of years? Or does “full employment” automatically lead to imbalances that represent the seed of the next crisis?
In the case of the US, history suggests that “full employment” is not a sustainable state and that once we reach such a level a sudden increase in unemployment is very likely. In the figure below I plot unemployment rates around the peak of each of the last five cycles (where zero represents the month the recession started). I plot 5 years before the recession started and 10 months after the recession.
Unemployment Rate Around Recessions (US)
All cycles display a V-shape evolution for unemployment. Unemployment reaches its lowest point around 12 months before the recession and, in most cases, unemployment is already increasing in the months preceding the recession. What is interesting is the absence of a single episode of stable low unemployment (or full employment). It seems as if reaching a low level of unemployment always leads to dynamics that soon generate a recession. Recessions die of old age if “age” is measured in terms of how much economic slack is left. If this pattern was to be repeated, the US must be today very close to an inflection point, a recession.
The result might sound obvious and mechanical: once unemployment rate is low, there is only one way for unemployment to go: up. This is true but what matters is whether a persistent period of low and stable unemployment is possible. In the case of the US the answer is no. One way to visualize this possibility is to look at other countries. A good example is Australia that has recently sustained a low unemployment rate for decades. After a recession in the early 1990s, unemployment increased and then started a decline through a path similar to any US expansions. By the year 2000 unemployment reached a low level that has remained mostly flat for years. In other words, the unemployment rate does not display V-shape dynamics but looks more like an open L-shape.
Unemployment Rate (Australia)
Growth at risk and quantile regressions
We can quantify this intuition by relating this result to an academic literature that analyzes the determinants of the tail risk of unemployment (or GDP) changes. This literature looks at the determinants of worst potential outcomes over a specific time window. Some examples: Cecchetti (2008), Kiley (2018) Adrian, Boyarchenko, and Giannone (Forthcoming).
Empirically this is done with the use of quantile regressions. In this case we are interested in the tail risk of sharp unemployment increases, which are associated with recessions, and I will capture that by coefficient on the 90th percentile of the distribution in a quantile regression (Fatas (2019)).
The results of such a regression are displayed in the table below. All three coefficients are negative (which is what one would expect as there is reversion to the mean in unemployment rates). But the interesting part is that the size of the coefficient increases as we move from small changes in unemployment to large changes (from q10 to q90). This means that low unemployment rates are particularly good at predicting the tail risk of large increases in unemployment (recessions)
Why is full employment unsustainable?
The pattern of US unemployment recessions suggests that low levels of unemployment are a strong predictor of sudden increases in unemployment, associated to crises. We do not observe in the data any sustained periods of low unemployment. But why is low unemployment unsustainable? What leads to a recession?
The academic literature tends to emphasize two set of variables: those associated to macroeconomic imbalances (such as inflation) and those associated to financial imbalances. Interestingly, the introduction of these variables in the quantile regressions above makes the above effect go away (see Fatas (2019)). In particular, once we control for credit growth, it is not any longer the case that low unemployment is a good predictor of the tail risk associated to recessions (we still observe a reversion to the mean but we do not obtain a larger coefficient for the p90 quantile).
This result suggests that recessions follow periods of low unemployment because imbalances are built during those years. What is interesting is that the evidence shows that this is always the case, that the US economy has never managed to sustain a low rate of unemployment without generating the imbalances that lead to a recession. If history is an indicator of future crisis, and given the current low level of unemployment, a recession is likely to be around the corner.
ON THE ECONOMY: GHOST RIDERS IN THE SKY
John Dunham, Managing Partner, John Dunham & Associates
Yippie yi ooh. Yippie yi yay. Ghost riders in the sky. Their faces gaunt, their eyes were blurred, their shirts all soaked with sweat. He’s riding hard to catch that herd, but he ain’t caught ’em yet. ‘Cause they’ve got to ride forever on that range up in the sky. On horses snorting fire, as they ride on hear their cry. The country-western classic, Ghost Riders in the Sky: A Cowboy Legend,” was written in 1948 by Stan Jones. It has been covered over 50 times, most notably by Vaughn Monroe in 1949, when the song topped the Billboard charts. My personal favorite is a 1979 version by Johnny Cash that he performed with the Muppets.
We talk about ghosts a lot in the Monthly Manifesto. This is because economics is a field that is particularly haunted by ghosts of the past, since most economic theories reflect the time when they were created. We have been hearing a lot about socialism these days, as nearly every Democrat Presidential candidate is tripping over themselves to show just how socialist they are.
The interesting thing is that its quite unlikely that any of these candidates, nor their current philosophical guru, Congresswoman Alexandria Ocasio-Cortez, actually knows what socialism is. Unlike the proposals in the so-called Green New Deal, socialism is not a philosophy about authoritarian government control.
Rather than what so-called Progressives propose, socialism is not about state control of the economy in which people are manipulated by a bureaucracy. Socialism involves a perceived level of freedom where individuals bring the productive forces of the economy under their collective control, and become independent productive entities no longer subject to the will of another class of people. In fact, socialism could not exist had not a capitalist economy created an economy productive enough to provide for all, and a level of society where individuals take responsibility for ensuring that production actually occurs. In other words, a socialist economy is much more like Galt’s Gulch from the novel Atlas Shrugged, then it is like Cuba, or Norway, or what is being proposed in the Green New Deal.
To understand the philosophy of socialism, one has to examine the period in which it was developed. The ideas of socialism sprang forth during a period of revolution in the Western World. In the Americas, colonial powers were being overthrown, while in continental Europe, the industrial revolution was leading to the overthrow of monarchs and the end of rule by the land-owning classes. In the United States, the shift from an even earlier form of economic structure (that of slavery) was about the be undermined by a bloody civil war. In effect, the economy was shifting from a feudal to a capitalist system.
Seeing all of this change, and the rapid increase in productivity brought about by capitalism, in 1845, Karl Mark and Friedrich Engels wrote The German Ideology. Much like The Wealth of Nations laid out the foundations of a capitalist market economy, Marx and Engel’s Manifesto laid out the philosophy of what they dubbed historical materialism. This philosophy was based on the idea that societies will naturally progress through levels of economic development determined by the division of labor between social classes, resulting in an end point where a classless society would exist.
The economy and society in 1850 were nothing like they are today. The vast majority of people still farmed the land, however, mass migration to the cities had begun. Large numbers of poorly educated workers were flooding the slums of Berlin, Paris, and London. These people were working in dingy, dangerous factories generally owned by one person or one family. In effect, the lives of factory workers were not much different than the serfs who had worked the land for the royal classes of the past. Now they simply worked for a different class of people, the bourgeoises. (This term was used by Marx to describe the social class of individuals who owned the means of production.) In addition, civil wars and wars between the remnants of the feudal rulers were causing more poverty and suffering.
From an economic standpoint, the vast majority of people lived in extreme poverty, subject to the whim of their employers. They were for the most part unskilled, uneducated, and undernourished. The loss of a job – even a bad job – could destroy a family. Poor houses, debtor’s prisons and workhouses were normal. At the same time, productivity was rising rapidly and the capitalist class was reaping most of the rewards.
While there are similarities to today’s economy, for example the owners of so-called technology companies are becoming super rich, while wages have stagnated generally. There are a lot more homeless and indigent people than in recent years due in part to the opioid crisis. The country has been in a protracted conflict, and there is a general sense of distrust of the current ruling class. All that said, poverty and depravation is nothing like it was in 1850s Europe. Social safety nets exist in all Western countries. The sick and indigent are generally provided for (not made to go to work houses). Bankruptcy laws keep people out of debtors’ prison, and poverty is at just 13 percent of the population – and even the poorest people live better than most did in the 1850s.
The people who are pushing for what is being called socialism today, aren’t actually socialists at all. Rather they simply want to ensure that a new ruling class (a class that includes them) controls the lives of the people. They are riding hard to catch that herd, but they ain’t caught ’em yet.