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Christopher Thornberg, PhD
Christopher Thornberg founded Beacon Economics LLC in 2006. Under his leadership the firm has become one of the most respected research organizations in California serving public and private sector clients across the United States.

In conversations about the economy, there are a lot of conventional wisdoms that are neither conventional nor wise. One very relevant example today is the idea that a recession is defined as two consecutive quarters of negative GDP growth, exactly what the United States experienced in the first half of 2022. This definition enjoys wide acceptance and shows up in all sorts of places—but a little logic quickly shows how slippery it is and why it shouldn’t really apply to the U.S. economy at this time.

This isn’t a universal definition. According to the National Bureau of Economic Research (NBER)—the self-appointed official daters of business cycles—a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months” and is “normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” With that broader definition we can deduce that the NBER will not call the first half of 2022 a recession, because out of all those indicators only one, real GDP, is showing a negative trend in the first two quarters of the year, and that decline is minimal. [1]

But even NBER’s definition, while more complete, leaves something to be desired. I would suggest that we need to be more specific about the dynamics behind the negative trends in an economy before we define it as a recession, as these dynamics will determine which policy tools the government should consider dealing with the economic difficulties. The distinction is whether the decline in output is a function of falling economic capacity (the maximum potential output of an economy) or a drop in the usage of that capacity (actual output falling well below maximum potential output).

There are many examples of economies seeing a real decline in their capacity. That could be caused by things such as natural disasters, war, epidemics, or changes in governance. But the more common event is typically linked to the business cycle (recession and recovery) where output is declining to a level below capacity. One of the best stats to observe this type of decline in output is the unemployment rate as it measures the share of workers who want to work but cannot find employment—unused economic capacity in its purest form. That economy would produce more if those looking for work were given jobs, but for whatever reason the labor market is not clearing so output remains below capacity. Recovery occurs when the economy grows back to its capacity. [2]

There are many potential reasons why an economy may underperform in this way, including the collapse of a financial bubble (2001, 2008) a pandemic (2020) or an oil shock (1974). These types of economic contractions suggest a specific set of policy responses—fiscal and monetary policy as might be enacted by the Federal Government and the Federal Reserve Such efforts have been described and calibrated by a mountain of academic economic literature. Unfortunately, most of the good outcomes described in this literature rely on a sensible use of such policies—something that has been tragically lacking in Washington DC over the past two decades, and particularly over the last two years.

This brings us back to the current state of the U.S. economy, where we have seen a decline in economic output for two consecutive quarters ending in June. But as noted, we have not seen the declines in other measures of economic activity. Industrial production remains near its all-time high level as of June, job growth has been surprisingly solid given ultra-low unemployment rates, job openings are still near record high levels, and inventory levels in many parts of the economy remain very low. This isn’t a recessionary economy by any means. This is an economy working at full capacity that still can’t seem to keep up with aggregate demand. This cannot be a recession.

If the economy is running at full capacity and output is falling, that suggests the problem is with the ability to produce output—a decline in capacity. Why is that capacity falling? One reason is the mass wave of retirements that occurred during the pandemic. The U.S. labor force contracted by 2 million people relative to trend—mostly high skilled workers with extensive experience. That loss of human capital, given over to golf courses and senior communities, should not be trivialized. These were workers at the pinnacle of their careers, with decades of experience. While the wave of retirements likely explains why U.S. GDP has struggled to get back to pre-pandemic levels, it happened in 2020, so it does not explain why the U.S. economy has contracted modestly in the first half of 2022.

Another reason for the decline in capacity has to do with the excessive use of government stimulus that has marked these last two years and the coordination problems it has induced at so many different levels. The market system at the heart of the U.S. economy has proven to be one of the best systems for allocating scarce resources to their best use and promoting economic growth. But this efficient allocation is not immediate. Deploying resources from one use to another within the economy is a time consuming and costly enterprise; machines must be retooled, workers retrained, infrastructure rebuilt. Economies adapt to slow changes much better than rapid ones.

But when we think about the U.S. economy of the last three years, we don’t see the slow, steady economic changes that characterize expansions. Quite the opposite, we have seen enormous movement in the various components of economic demand. The pandemic itself caused a large portion of the economy to functionally close. Some of this unrequited demand moved into spending on goods, quickly leading to a surge in spending far above normal in some parts of the economy.

On top of these twists and turns, policymakers then threw a preposterous amount of stimulus at an economy that didn’t really need it. Congress engaged in $6 trillion in deficit spending and the Federal Reserve functionally monetized the deficit with $5 trillion in quantitative easing. The impact of such massive stimulus was correctly predicted by Milton Friedman in the first chapter of his 1980’s book Money Mischief. Interest rates fell, there was a surge in asset prices from homes to equities, and overall consumer spending jumped. All of which, in turn, caused a surge in business investment.

Unfortunately, as Friedman described, this excess demand eventually sets off inflation and quickly drives longer term interest rates up. The Fed has responded to inflation by jacking up the Federal Funds rate up very sharply. Washington DC’s spending binge has also quickly cooled. Debate within the Democratic party and sudden resistance by the Republicans (who always seem to become deficit hawks when they don’t control the White House) has caused the Federal deficit to shrink back to its pre-pandemic level.

With such violent starts, swerves, and stop is it really any wonder that the U.S. economy is running at full capacity and still shrinking in the aggregate? It’s like driving an 18-wheel truck through an obstacle course designed for a dune buggy—the machine simply is not meant for this kind of terrain. And this explains why so much U.S. demand is being met by inventories or imports—the economy is unable to redeploy inputs to keep up with rapidly shifting demand and the wrong output gets produced. Think of the piles of pajamas and sheet sets laying around Walmart and Target now because of bad planning in those headquarters… but now apply that same story to the overall economy.

Good economic policy should try to make gradual moves. Consider Ben Bernanke’s $3.5 trillion in quantitative easing over six years contrasted with Jerome Powell’s $5 trillion in two years. This is why fiscal stimulus should focus on slow moving government spending rather than on simply transferring mass quantities of cash to the private sector occurred through household stimulus checks and payroll protection subsidies.

The good news is that if things calm down, the production side of the U.S. economy will sort itself out, improving efficiencies and returning to a solid growth path. The bad news is things aren’t likely to calm down in the near future. After all, the Fed has yet to truly curb inflation, financial markets will soften further from their pandemic-stimulus-driven frenzied highs, business investment is grappling with the very sudden increase in interest rates, and the U.S. economy is about to see a strong dose of fiscal pain as higher interest rates quickly drive up the cost of the debt the Federal government is carrying.

There is plenty to worry about in the months and years ahead, but one of those things is not that the U.S. economy is currently in a recession.

[1] This can be contrasted to the tech-recession that occurred at the start of the century when U.S. GDP contracted by only a small amount and never contracted for two quarters in a row. At that time, all the other indicators cited by the NBER showed clear signs of distress, explaining why the NBER would label that period a recession but not this one.

[2] Full recovery from a recession is when the economy returns to operating at capacity. The ‘Great Recession’ was actually an 8-year business cycle—6 quarters of declining output ‘the recession’, followed by the 6.5 years it took to get back to producing at full capacity ‘the recovery’.

The following two tabs change content below.
Christopher Thornberg, PhD
Christopher Thornberg founded Beacon Economics LLC in 2006. Under his leadership the firm has become one of the most respected research organizations in California serving public and private sector clients across the United States.

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