Slowing Down To Catch a Breath: The Economics of a Recession

The hard thing about economic cycles is that it is very hard to predict when an economy is sliding into a recession or moving to a period of sustained growth. Imagine that you are a fish in a fishbowl oblivious of the universe outside. Being in a recession is a similar feeling. The National Bureau of Economic Research (NBER) is the official date keeper of a recession. It defines a recession as  “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDPreal income, employment, industrial production, and wholesaleretail sales.” Most of the experts predict the U.S. economy to slow down in 2019. The implication is clear—we may be at the beginning of a recession and not even know it until we wait and watch how the subsequent months will unfold. You will typically see the media talk about recession when the short term and long-term yield curve are closer to convergence.

Typically, the long-term yield on bonds should be above the short-term yield to compensate investors for holding the bonds longer. The 10-year Treasury bill yields 0.19 percent higher than the 2-year Treasury bill as measured by the Federal Reserve of St. Louis (FRED) on January 19. If this equation “inverts,” i.e., the 2-year yield becomes higher than the 10-year, we know that we should start preparing for a recession. Today, you can expect more talk and less certainty around a recession. The yield on a 10-year Treasury may continue to be higher which may signal a slowdown short of a full-blown recession. We need to look at multiple factors such as a decline in house and asset price levels, three-month change in unemployment claims in addition to the yield curve to deduce a recession.

A recession will cause employers to save more and spend less. One way they save is to reduce salaries or maintain salaries at a constant level. This, in turn, induces consumers to spend less and save more. This behavior, in turn, means lower spending on goods and services creating a self-reinforcing cycle of de-growth. There are many different responses to a recession. One approach is for the government to lower interest rates, flood the economy with liquidity (quantitative easing) and increase spending to spur economic growth. The U.S. already adopted this approach to move its economy out of the recession caused by the 2008 financial crises. Therefore, many economists think that monetary policy does not have any tools left. In fact, the U.S. Federal Reserve is now reversing its approach with rate hikes announced earlier in 2018. The other options is to reduce taxes. Once again, tried before. According to Kenneth Rogoff, a professor at Harvard and former chief economist at the International Monetary Fund “If we have a recession, I think it’s going to be worse than normal.”

The word ‘recession’ has a very negative connotation attached to it. It is a word that invokes feelings of doom and gloom and rightly so. However, the correct way to look at it is to think of it as the economy slowing down to catch a breath before marching ahead again. In other words, a recession is an inevitable outcome in economic cycles. If the economy continues its growth streak, very few things will remain affordable as inflation keeps climbing up. Recession is a natural way for the economy to correct its course albeit in a very painful and protracted manner. We have to accept it just as we accept seasons turning. As with any other change, we prepare for it. A recession can signal a slowdown in wage growth. This means household savings should be more accessible in the form of liquid assets such as savings accounts to tide over emergencies such as loss of a job with medical benefits. Diversifying sources of income and identifying other markets for your business are other solutions.

Most people would tell you a recession is very bad. However, there are worse things that can happen to an economy such as stagflation. Stagflation is a portmanteau of stagnation and inflation. It is an economy with zero or slow growth coupled with rising inflation. Keynesians did not think of stagflation as a scenario. As unemployment rises, people have less money to spend. When coupled with rising prices, it means that the real value of a fixed paycheck goes down.

The reason Keynesians never thought of stagflation as a scenario is because they rely on an important inverse relationship to decide their economic policy. Unemployment and inflation typically have an inverse relationship. In economic lingo, this relationship is known as the Philips curve. Inflation is higher in periods of low unemployment and vice versa. In the 1970s, when the U.S. government adopted a loose monetary policy, it created inflation. The wage earners expected their employers to raise their wages in line with the increased prices. The employers did that for a while. After a period, employers stopped increasing wages until inflation outstripped wages. If a government continues to pump more money in periods of rapid inflation but sagging output, it results in too much money chasing fewer goods. This was the classic definition of inflation as defined by Milton Friedman. The moral of the story is that it is very dangerous to increase the money supply in a recession rapidly. The Federal Reserve needs to be able to predict the inflection point where the economy is turning around. Otherwise, a recession could become stagflation.

It is very clear from the above discussion that monetary policy and government intervention are instruments of both art and science. This is where macro-economic indicators and frameworks can guide decision-making. A CEO of a company, as well as a common person, faces many such situations of ambiguity. While there is no single solution to deal with all problems, there are certain thumb rules. The number one thumb rule is to avoid excess consumption when the economy is booming. It is very important to keep at least 6 months’ worth of earnings tucked away for a rainy day. It is even better if one years’ worth of earning are lying in savings bank accounts. Cycles are an inescapable force of nature. There is a very dark aphorism about what caused the decline of the Roman Empire—too many Toga parties. For the sake of our families, we can rename Toga parties to mean just one thing—complacency.