Tuesday, March 5, 2013

What Will the Next Recession Look Like? Part II

In this post, I want to continue my thoughts on the next recession in the US, by nothing this point: it stands a high probability of being shallow.

As I noted yesterday, most recessions start as a result of interest rate increases, oil price hikes or the bursting of an asset bubble.  Consider the macro-level impacts of these events.  The former impacts the entire business community, driving up the cost of money thereby lowering loan demand for everyone.  The latter effects consumer spending, as higher energy prices take a bigger percentage of consumer purchases, thereby lowering discretionary income for spending on everything else.  And the collapse of an asset bubble effects everyone's confidence.

All three of the preceding events have one thing in common: they immediately have a large effect on wide swaths of the economy.  And once these effects are felt by those directly effected, the impact continues to more indirect areas of the economy.  For example, as business lending decreases, business expansions decrease, leading to a drop in employment, leading to a slowdown or drop in income.  As consumer spending drops, business profits drop, leading to a decrease in employment, leading to lower incomes etc... Asset bubble's breaking lowers everyone's confidence all at once.

The point of highlighting these standard recessionary causes is that because they impact a large percentage of the economy, they stand a higher chance of slowing the economy at a brisk pace.   But they also usually only occur when the economy is operating close to full capacity.  Inflation heats up when there is either sufficient demand to pull prices higher or insufficient supply of a commodity or group of commodities.  Oil prices spike because of increased demand which is the result of an economy operating near full strength.  And asset bubbles traditionally pop at the end of an economic expansion -- or cause same.

In contrast to the preceding events, the US economy is currently operating one or two steps above recessionary levels.

First, consider this chart that shows the year over year annual growth in GDP.

I've drawn a red line from the peaks of the current expansion through the other GDP data points.  Simply put, this expansion is a lot weaker.  While that's not good from the current perspective, it also means that the the economy has less far to fall.  Let's make the same point from two other economic data points.

Looking at the employment data, the top chart shows that the US economy is still 3 million jobs below the previous peak.  The second chart shows the unemployment level is still high by historical standards (we're nowhere near full employment) and the third chart shows that overall establishment employment growth has been weak.  Putting all of these charts together, we can make a convincing argument that employment levels are already at semi-recessionary or recessionary levels. 

Finally, consider this chart of real potential GDP and real GDP:

We're already currently operating below optimal potential capacity. As with the employment charts, we can make a good case that the economy is already operating at a semi-recessionary pace.

The some total of all the above charts is this: the US' current level of activity is just one step above recession.  It wouldn't take much to send us into negative growth.  But it also means the level of contraction stands a higher probability on being shallower, largely because the three primary causes of recessions won't cause the recession itself and we're already operating in a semi-recessionary environment.