The Elusive Meaning of Jargon

Frequently the cottage industry, that includes journalists and economists, come up with post hoc explanations for economic phenomenon, using words and phrases which after a while lose much of their original significance. Examples last year included yen-carry trades and risk-aversion. Now the words recession and stagflation are being bandied about, with little effort to define one’s terms.

There does not appear to be a universally accepted definition of recession. Historically speaking, in the United States, the end of the business cycle was called a depression or crisis. In fact, it appears that the word recession and depression were largely interchangeable. For example, among the earliest uses of the word recession to apply to the business cycle was in the Economist (1929) but after the devastation of the Great Depression in the 1930s, economists and politicians wanted to distinguish a temporary and relatively shallow decline in economic activity from the kind of collapse that was evident then.

A frequently cited definition of a recession is two consecutive quarters in which GDP contracted. There are many problems with such a definition. There are other variables that economists, policy makers and investors probably ought to take into account, such as employment for example. Also quarterly data might not be sufficiently granular to detect short downturns in activity.

In the US, the official arbiter of recessions is the National Bureau of Economic Research. The NBER says a recession is a “significant decline in economic activity spread across the economy, lasting for more than a few months.” It looks at a number of economic variables, like employment, industrial output, real income and wholesale and retail sales. It dates the start of a recession at the peak of business activity and the end of the recession/beginning of the expansion when business activity bottoms. This helps explain why the NBER’s dating of a recession takes place with large lags.

One of the most remarkable developments that few seem to appreciate is that the US business cycle has become flatter and longer than in the past. There may be numerous contributing factors, like better inventory management, flexibility of the capital markets and the increasing importance of the service sector. The US economy has experienced five quarters of negative growth in the past 17 years and seven quarters of negative growth in the past quarter century.

There are two main culprits the market often cites as causes for economic downturns. First are external developments, like the oil shocks in the 1970s or the first Gulf War in the early 1990s. The second is the Federal Reserve. Both seem exaggerated.

Sure external variables can tip the economy over, but only, it seems, if it is already vulnerable. Look at the oil shock of recent years. There have been pundits claiming at nearly every $10 a barrel increase over $40 as intolerable from an economic point of view. And if the US economy expands by 1.5% in Q4 07, which seems like a reasonable conservative estimate, that would place H2 07 growth at an impressive 3.2% pace, a pace that most industrialized countries would envy. In 2001, the US was emerging from the business downturn just as many had expected the exogenous shock of 9/11 to drive it into a recession.

The Federal Reserve is also often cited, especially in some political quarters, as responsible for economic downturns by setting monetary policy too tight for too long. When he was much younger and under the influence of Ayn Rand, former Federal Reserve Chairman Alan Greenspan seemed sympathetic to such a view. Yet the historical record suggests otherwise. That is to say the business cycle existed long before the Federal Reserve was created (1913). As noted above the amplitude of the business cycle has been reduced and the durations of the business cycle have lengthened.

This raises the issue of the business cycle itself. There is one camp that argues that the seeds for an economic downturn are planted during the expansionary phase. Another camp says that the end of the business cycle is due to factors outside the business cycle. There has been much ink spilled in defense and criticism of each camp. Suffice it to say that it does look like business cycles are like people in that they can die of old age and not just be murdered.

The issue of defining a recession is not just academic, but there are important policy and investment implications. For example, over the last several cycles, it has taken the real Fed funds rate (Fed funds adjusted for inflation) near zero to reinvigorate the economy. Also, past economic downturns often have led to fiscal stimulus, beyond the usual counter-cyclical spending, like unemployment compensation.

On both counts policy developments do not appear to be waiting for the NBER or two quarters of negative GDP. In recent days the US President and senior Democrats appear to be favoring a modest fiscal stimulus of say $50-$100 bln. In addition, the 4.25% Fed funds rate, which is likely to fall to 3.75% at the end of the month, contrasts to a 4.3% year-over-year rise in headline consumer prices in Nov. The Dec figures will be released at the end of next week and the consensus calls for a 4.1% pace (and subjectively the risks look to be on the upside).

Stagflation is also a slippery word that seems to defy clear definitions. The generic meaning is sluggish growth coupled with price pressures, something that classical and neo-classical economists did not think possible. Yet the connotation is of the 1970s, when inflation was double digit and unemployment was say rising from 6% on its way to almost 11% by the end of 1982.

Although some pundits are referring to current conditions as stagflation, this seems to exaggerate inflation and unemployment or the slowing of the US economy. Moreover, it seems not to appreciate that the business cycle and the price cycle are not always (or arguably, even usually) in sync. As is well appreciated prices often tend to be sticky.

So is the US in a recession or headed for a recession? Is it experiencing stagflation? Like beauty, the answer lies in the eyes of the beholder. The politicians are already acting as if the recession is here, though this may also be a function of the electoral cycle as much as the business cycle. Although Federal Reserve Chairman Bernanke validated market expectations that the Fed funds rate will be cut by 50 bp at the end of the month with the real Fed funds rate staying below zero, he was clear that a recession was not the Fed’s baseline forecast.