The Strange Definition of Recession Is the Best We Have

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With talks of recession everywhere, and the midterm elections looming, there has been a lot of talk from the White House attempting to downplay souring economic conditions. This has occurred as the Council of Economic Advisers first, and the Treasury Secretary second attempted to move away from the most common definition of recession – namely two consecutive quarters of negative GDP growth.

Whatever you think about the odds of recession and the culprits if one were to take place, the political spin lies on a foundation of truth: The “two consecutive quarters” rule is weak.

To show you how, let me tell you a story from recent Canadian economic history. In 2015, on the eve of a federal election, Canadian GDP numbers began showing negative growth. In the middle of the election, GDP numbers for the subsequent quarter became available. They too showed negative growth. Ergo, Canada was in a recession. The media hype around that “recession” helped sink the Conservative Government of Stephen Harper, who was forced to return to the status of official opposition party.

Yet, if you ask any Canadian economist, none will agree that the “recession of 2015” was a false one. First, there had been negative growth in most of the first of the two quarters and in the first two months of the second negative quarter. However, growth was positive and so strong in the last month of the second quarter that it had erased close to 60 percent of the reversal observed. An extra month of data and the entire “recession” was over. By that standard, the recession of 2015 in Canada was the recession in which the economy recovered – a mere two months were needed. Second, there was no decline in employment during the “recession”. In fact, there was an increase at the national-level.

What happened? Well, one needs to understand that economies are not without frictions. Moving resources such as workers, capital equipment, machinery, and offices is not immediate. Nor is it costless. This matters, because it means that one can mislabel things dangerously.

Imagine that one sector of the economy sees an unexpected and substantial increase in foreign demand. This pushes up the price for that sector’s output. However, previous patterns of production were organized in ways that reflected the previously lower price of that sector’s output. Firm-owners, workers, and capital-owners realize that shifting between sectors offers greater return. As a result, firm-owners downsize certain operations in order to up-size previous ones. Workers leave other industries to work in the booming one. Capital owners prefer to lend equipment and funds to firms in the booming industry. As these economic actors shift resources to the booming industry, the production from other industries falls. This reduction happens before the new, and more valued, output from the booming sector has been fully realized.

In the data, this will show up as a recession. The economic meaning, however, is entirely different. Actors expect a more productive situation. They expect greater growth. This means that once the economy has fully adjusted to such a positive shock, income will be greater than it had been before the shock. This is hardly a development that speaks of recession.

The same story can be told with some twists if the shock is negative for a single industry. It simply happens in reverse as workers, capital, and businesses exit the flagging industry in favor of other industries. At worst, this implies a slowdown in economic activity due to the negative shock. However, the economy as a whole will suffer only in proportion to the industry’s share of the total economy. At best, there may be no effect if one industry is booming due to an unexpected positive shock, while another is suffering due to an unexpected negative shock.  

The latter is what happened in Canada during 2015. Some industries were enjoying important booms while there was a downturn in international demand for oil. Petroleum extractors in Alberta and Newfoundland diminished operations as other sectors were also better able to attract workers and capital from that industry. During the adjustment, there was some lost output, but the economy was back on track really fast without any fall in employment rates or changes in payroll levels.

Most of the shallow and deep recessions in economic history were associated with output declines across multiple industries. This is a more relevant definition than that of the two consecutive quarters of negative growth. The problem is that it is quite hard to define a threshold in such a case. What should be the qualifying number of declining industries? What share of the economy’s output should they represent? Such definitions would be incredibly arbitrary or very context-specific.

The reality is that the reason many use the flawed rule is because all other alternatives seem to be worse. As such, politicians and pundits who try to downplay talks of a recession by mentioning the flawed rule may be politically, and not economically inclined.  

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