Choosing Recession: Well Written and Worth the Read

Choosing Recession
Lakshman Achuthan and Anirvan Banerji 04.21.08, 6:00 AM ET 


The 2008 recession guarantees many months of job losses that will boost foreclosures and feed the credit crisis. But if fiscal stimulus had reached consumers quickly, it would have forestalled a recession, helping to stabilize the housing market. Such a soft landing would have bought some breathing room in which to resolve the credit crisis until the lagged effect of monetary policy kicked in.

There is a raging debate about how the economy got into recession, and who is to blame. Many have concluded that the housing and credit bubbles guaranteed recession. But because this debate will influence policy for the next economic cycle, the right lessons must be learned from this series of unfortunate events.

An essential point is being overlooked–that this recession was actually avoidable as recently as several weeks ago. How could that be?

The Fed has rightly been lauded for its bold actions this year, but they hardly make up for its initial delay in getting serious about averting recession. Because monetary policy affects the economy with a lag, the Fed must be preemptive, not reactive. But, as in the lead-up to the 2001 recession, inflation concerns based on backward-looking indicators needlessly inhibited the Fed’s actions for far too long. This implies a fundamentally flawed monetary policy approach because inflation typically keeps rising in the early months of recession. More importantly, forward-looking inflation indicators were already falling last summer. The Fed had a green light to slash rates that it failed to heed until January. The Fed cannot afford to act like a deer in the headlights frozen in the face of higher food and energy prices that it cannot control.

As the new year began, The Economist noted, “One of the most reliable gauges is [Economic Cycle Research Institute’s] weekly leading index [which] is now showing its weakest performance since the 2001 recession.” But it also cited our view that “prompt policy stimulus could still avert a formal downturn.”

Shortly thereafter, Chairman Bernanke not only began aggressive monetary stimulus, but also endorsed quick fiscal stimulus, emphasizing that “it would not be window dressing.” Apparently realizing that the economy was on the cusp of recession, he may have understood that only timely fiscal stimulus could save the day. Given the history of fiscal stimulus arriving too late to head off recession, how was that even possible?

Prominent pundits have been predicting a U.S. recession since 2005, when Hurricane Katrina hit an economy under assault from Fed rate hikes and oil price spikes, a combination that had triggered many a past recession. With the advent of the home price downturn, the gloomy chorus grew throughout 2006.

In early 2007, Wall Street analysts were predicting up to 100 basis points of Fed rate cuts by year end. By June, faced with accelerating economic growth, they abruptly switched their call to zero rate cuts. The economy’s unexpected resilience actually triggered the credit crisis by invalidating expectations of modest resets to subprime adjustable rate mortgages.

U.S. growth plunged following the credit crisis, but the economy grew stubbornly through year end. Still, persistent pessimism made the dollar swoon further, cementing an export-driven boost to manufacturing.

The constant drumbeat of downbeat commentary compelled CEOs to aggressively reduce inventories, cutting the inventory/sales ratio to a record low by late 2007. For the first time, premature pessimism had created a unique opportunity for a self-correcting recession prophecy. At that juncture, even if consumers had spent only a fraction of the stimulus on consumption, in the absence of inventories it would have forced businesses to boost production and hiring, thereby stabilizing the job market.

Typically, business managers, surprised by recession, face a Wile E. Coyote moment when they realize that demand has plummeted. Stuck with soaring inventories, they slash production and jobs, thereby reducing consumer income and spending, which in turn feeds back into lower sales, triggering further production cutbacks, perpetuating the vicious cycle that is the hallmark of recession.

In every recession, the manufacturing sector accounts for more than half of the job losses, largely due to this inventory cycle dynamic. But this time, with inventories cut to the bone, this key recession driver was absent. Prompt stimulus would have been unusually potent, quickly reversing the recessionary vicious cycle.

Policy makers seemed to get the urgency. In January, Treasury Secretary Hank Paulson declared that “time is of the essence.” House Speaker Nancy Pelosi spoke of “timely, targeted and temporary” stimulus, and the administration and Congress enacted a tax rebate package with exemplary speed. The fatal flaw was their willingness to allow a delayed delivery of the stimulus. It was as if the medics had arrived and taken a quick decision to administer CPR–but in a few months rather than a few seconds.

Given the magnitude of the housing and credit bubbles, there was no way to avoid paying the piper once they had popped. But in this instance, resolving those excesses did not require a recession, which could have been forestalled by quick stimulus. Just as the Fed has demonstrated out-of-the-box thinking in recent weeks, so too fiscal policy makers needed to have found innovative ways to get money to the consumer in weeks, not months. That would have made all the difference.

Arguably, in a market economy, recessions are cathartic. But choosing recession is causing unnecessary collateral damage to millions of innocent bystanders while making it politically expedient to throw far more money at the problem than was needed to avert recession in the first place. Moreover, recessionary job losses will worsen the housing downturn.

Alan Greenspan recently emphasized the abrupt shifts that occur at business cycle turning points, noting that “you don’t gradually fall into recession, you jump.” That is precisely why the timing of policy is so critical in the vicinity of turning points.

In February, ECRI’s leading index for the nonfinancial services sector, which accounts for five out of eight U.S. jobs, locked onto a recessionary trajectory. In effect, the 3 a.m. call on the economy had gone unanswered.

Lakshman Achuthan and Anirvan Banerji are the co-founders of the Economic Cycle Research Institute, and the co-authors of Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy, published by Currency Doubleday.


One Response

  1. Good stuff, and the point that it was actually possible to dodge recession recently is one that is being glossed over. Makes me mad that because the point was not understood by Washington we’ll be spending loads more money. Some things never change.

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