• Anticipating the Next Recession
  • In a Downturn, the Eurozone Would Fare Poorly
  • Fuel for Concern
  • It is said that economists have predicted nine out of the last two recessions, and that they are people who can find a dark cloud behind every silver lining. The profession does have a tendency to overestimate risks and underestimate resilience.

    As the global expansion reaches an advanced age, though, the odds of a recession are increasing. The capacity required to support growth is dwindling, and central banks are slowly normalizing monetary conditions. Poorly conceived fiscal, monetary or trade actions usually precipitate downturns, and the list of potential missteps is long.
    Recessions are inevitable in market economies. But the depth and duration of downturns can vary considerably based on the events that trigger them, the manner in which they spread and the steps taken to respond. On that last front, there is significant concern that policy makers have little room to provide relief if the present expansion ends anytime soon. And that could make the next recession an especially difficult one.

    For the moment, the global economy is performing well. The United States is enjoying its second-longest expansion, Europe continues a nice advance (despite impending Brexit), and China has sustained a record of performance that is unparalleled in the modern era of economic development. While some emerging markets are faltering, many are riding the coat-tails of progress seen in larger countries.

    Nonetheless, concerns of a recession are gaining attention. Recent polls suggest a plurality of forecasters think the current American expansion will not last more than two additional years, while the odds of a downturn by 2020 in other areas are rising.

    Before anyone gets overly alarmed, some background is in order. Surveys and models that attempt to predict recession have wide margins of error. A number of economic research groups have created equations that attempt to predict recession likelihoods based on growth momentum, financial conditions and other leading indicators. Increasingly, algorithms are evaluating these elements globally, to account for the expansion of international commerce. The output is certainly interesting to look at, but substantial uncertainty surrounds the results.

    The yield curve has been getting a lot of attention as a recession indicator lately. In the United States, inversions of the yield curve (where short-term rates are higher than long-term rates) have been seen prior to the last five recessions. As the two ends of the U.S. yield curve approach one another, some have taken this as a sign of slower times ahead. But the predictive power of the yield curve is not absolute (some false positives and long lags), and increasing international ownership of U.S. Treasury securities may cloud its value as a leading indicator.

    Further, many recessions are brief and relatively mild. The United States has had seven downturns in the last 50 years: the shortest was six months, and the longest was 18 months. The average increase in unemployment during these phases has been 2.5%. Economic retreats are never pleasant, but many are relatively shallow. And sharp recoveries
    often follow, limiting any
    lasting economic damage.

    As we think about what might lie ahead, there are other reasons for comfort. In most countries, leverage in the household sector is well down from its extremes of a decade ago. Financial institutions have been prodded by markets and their regulators to increase capital, which should limit the likelihood of 2008-style contagion. And use of exotic financial instruments that are not traded on exchanges has fallen substantially from a decade ago.

    On the other hand, the policy makers’ ability to buffer the next downturn may be very limited. When recession sets in, central banks cut interest rates and legislatures typically increase government spending to compensate for faltering private demand. Both of these avenues were generously applied in the years after the 2008 crisis.