Etienne Monceau

He studied engineering and quickly discovered a passion for markets. He is also a fan of surfing, snowboarding and wide open spaces. He dreams of a democratized financial world, where everyone can make their assets flourish, ignoring the jargon of experts and having the right information. At Marketscreener, he deploys his love of fundamental analysis (and company balance sheets!).

Recession: What are we talking about exactly?

07/01/2022 | 05:35am EDT

Right now, the number one risk for markets is the possibility of a recession in developed countries, particularly the US and the Eurozone. But what is a recession? What are the criteria on which supervisory bodies and banking institutions agree to call it a recession?

The main point:

According to the OECD, the GDP measure alone is not sufficient to identify the onset of a recession. Instead, the organization relies on the output gap, a measure that we will take the time to explain. In the United States, it is the National Bureau of Economic Research (NBER) that officially declares recessions. Like the OECD, the bureau believes that the GDP measure alone is not sufficient. It relies on a much larger number of indicators, which we will discover. If we stick to all the definitions of the above-mentioned actors (OECD, NBER), neither the United States nor the Eurozone have entered their recession phase, which is an integral part of long cycles and therefore seems inevitable.

Economic cycle

Recession according to the OECD

The output gap is the difference between the actual output and the potential output of an economy. It is therefore an unobservable variable since it is surrounded by uncertainties. Think of potential output as the maximum output - of goods and services - that an economy can sustain without overheating. This potential output can be obtained using the Cobb-Douglas function.

In simple terms, this function is a sort of weighted average of production factors such as employment and capital. The expression of the function - and thus the weight of each factor - is the result of econometric work: we recover the historical production figures over a period, we select a set of factors that seem more or less relevant and we let the magic of math work. A multilinear regression with the method of least squares allows us to obtain the weight of each of these factors, weights that are optimal in the sense that they minimize the difference between the real production and the production calculated by the model.

Once the model is built, we are able to calculate the marginal productivity of a factor - also called input -. In other words, we can estimate the effect of an increase of one unit of this input on the increase in production. It is thus possible to get an idea of the potential output of an economic zone.

If actual output is higher than potential output, the output gap is positive, and it increases progressively in periods of expansion, usually accompanied by a decline in the level of output. This is usually accompanied by a fall in the unemployment rate and upward pressure on production costs, including wages, with a delayed effect on inflation. Indeed, on March 11, 2021, the ECB quoted in its macroeconomic projections that "with respect to inflation, the positive output gap is expected to translate into inflationary pressures in 2022. "

Economic crises, on the other hand, are accompanied by a widening of the output gap, but in the negative area. Real output is less than what could be produced at full capacity. This reflects too little demand and unused capacity.

The output gap is a variable that inflates and deflates - sometimes reverses - and accompanies the various economic cycles. When this gap widens, whether up or down, it is never a good sign. In one case it is overheating, in the other it reflects a sluggish activity.

The fact is that the OECD uses this measure - an approach that has been criticized many times - to identify an entry into a recessionary phase. Actual output at least 1% below potential output in a year is one of the criteria the organization uses to define a recession.

The problem of measuring growth by GDP

In a recent article called "Let's count what really matters" published on Project Syndicate, Jayati Ghosh shares her views on the limitations of GDP. She argues that measuring the growth of an economy only by the sum of value added created does not capture the way wealth is distributed, the importance of social activities, and the need for a better understanding of how the economy works. The importance of social activities, the quality of life and, above all, the sustainability of the various systems at the very root of the economy's functioning. Data that seem crucial and allow us to understand if the growth of the GDP is healthy.

She describes the pandemic period to highlight the fact that the essential services that allowed the largest nations to get out of the water were largely underestimated in the simple calculation of gross domestic product. On numerous occasions, she also uses the example of India, which, from an outside perspective and blinded by GDP, appears to be a growing nation, while many factors reveal major societal problems  - such as access to healthy food and the labor market -.

With the UN's High-Level Advisory Board on Economic and Social Affairs, of which she is a member, she has taken up the challenge of Antonio Guterres, Secretary General of the United Nations, to get down to work and propose alternative measures. Among them, the median wage multiplied by the employment rate, access to a healthy diet, an activity indicator - which would capture, among other things, the activity of men and women who stay at home to care for the household - and carbon dioxide emissions per capita.

The concept of recession in the United States:

In the United States, there is still some people who consider the decline in GDP over two consecutive quarters to be the signal of a recession. The National Bureau of Economic Research (NBER), which officially declares recessions, maintains that these criteria are no longer the ones on which economic actors should base themselves to identify such an event. The bureau believes that a greater number of factors must be taken into account.

Recessions are characterized by a significant drop in industrial activity, GDP, wholesale and retail trade and a sharp rise in the unemployment rate. The bureau uses macroeconomic indicators such as the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, the OECD Composite Leading Indicator - hello OECD - and the yield curve study. Finally, the real and lagged indicators allow us to confirm the transition from an expansion phase to a recession phase.

You will see that such a methodology without setting precise levels or phenomena allows NBER to gain flexibility and adapt to each potential regression and its own set of characteristics. On the other hand, not defining rigorous levels leaves room for interpretation and many debates can emerge if the bureau is not consistent in its approach.

In February 2020, the NBER announced that the U.S. economic expansion  - long cycle - was over. Historically, the economy takes between 6 months to 7 years to return to its prosperous growth cycle  - you will agree, historical data does not help us much in knowing where the low point is -.

And where are we today?

At the time of writing, the NBER has not declared that the US economy is in recession. So, according to them, we are in an in-between period in the long cycle.

If we stick to all the definitions mentioned above - OECD, NBER -, neither the United States or the Eurozone have entered their recessionary phase.

We will get more clues very soon - on July 28 - when the first growth estimates for the second quarter in the United States are published. Even a slightly negative figure would indicate that the world's most powerful economy has entered a technical recession - two consecutive quarters in which the GDP growth rate is below 0 -. This technical recession would force officials, notably the Biden administration's advisors, to revise their rhetoric and start the second phase, because the figures will not stop there: inflation rose sharply in May - 8.6% at an annual rate -. This inflation weighs on expectations, whether for metrics that affect the consumer or those that assess business activity. In fact, the University of Michigan's confidence index is at an all-time low, which simply reflects the fact that households are anticipating a more deteriorated environment than they are today. The only short-term positive is the post-Covid reopening effect: occupancy rates are recovering in the US and elsewhere and prices paid are high. The risk is that once the summer is over, there will be a normalization on this side and that the pressure will be felt on services as strongly as on goods today. 

© 2022