The strange definition of a recession is the best we have

There is talk of a recession everywhere and the midterm elections approaching, and the White House has been talking a lot about trying to downplay the adverse economic conditions. It has originated as the Council of Economic Advisers first, and Minister of Finance the second attempt to move away from the most common definition of a recession, namely two consecutive quarters of negative GDP growth.

Whatever you think about the likelihood of a recession and its culprits, the political ploy is based on the truth: the “two quarters in a row” rule is weak.

To show you how to do this, let me tell you a story from Canada’s recent economic history. In 2015, on the eve of the federal elections, Canada’s GDP began to show negative growth. In the middle of the election, GDP figures for the subsequent quarter became available. They also showed negative growth. Consequently, Canada was in recession. The media hype surrounding this “recession” helped to sink Stephen Harper’s conservative government, which was forced back into the status of an official opposition party.

However, if you ask any Canadian economist, no one will agree that the “2015 recession” was false. First, negative growth was observed during most of the first of 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 erased almost 60 percent of the observed reversal. An extra month of data and the whole “recession” is over. By that standard, Canada’s 2015 recession was a recession in which the economy recovered in just two months. Secondly, during the “recession” there was no reduction in employment. In fact, there has been an increase at the national level..

What happened? Well, you need to understand that the economy is not without friction. The movement of resources such as workers, capital equipment, machinery and offices is not immediate. And it’s not free. This is important because it means that things can be dangerously mislabeled.

Imagine that in one sector of the economy there is an unexpected and significant increase in external demand. This pushes up the price of products in this sector. However, previous production patterns were organized in a way that reflected the earlier lower price of the sector’s products. Business owners, workers, and capital owners are realizing that moving between sectors brings great returns. As a result, the owners of firms reduce some operations in order to increase the volumes of the previous ones. Workers leave other industries to work in a rapidly developing one. Capital owners prefer to lend equipment and funds to firms in a booming industry. If these economic actors move resources to a booming industry, production in other industries falls. This reduction occurs before the new and higher value products of the booming sector are fully marketed.

This will show up in the data as a recession. However, the economic meaning is completely different. actors expect more productive situation. They are expect more growth. This means that once the economy fully adjusts to such a positive shock, income will be greater than before the shock. It is unlikely that this development indicates a recession.

The same story can be told with some twists if the shock is negative for one industry. It just happens the other way around when workers, capital, and businesses leave a lagging industry for other industries. At worst, this means a slowdown in economic activity due to a negative shock. However, the economy as a whole will suffer only in proportion to the industry’s share of the overall economy. At best, there may be no effect if one industry booms because of an unexpected positive shock and another suffers because of an unexpected negative shock.

The last one happened in Canada in 2015. Some industries experienced significant booms while global demand for oil declined. Oil companies in Alberta and Newfoundland cut back as other sectors were also better able to attract workers and capital from the industry. There were some production losses during the adjustment, but the economy returned to normal very quickly without any decline in employment or wage changes.

Most of the shallow and deep recessions in the history of the economy were associated with a decline in production in many industries. This is a better definition than two consecutive quarters of negative growth. The problem is that in this case it is quite difficult to determine the threshold. What should be the qualifying number of shrinking industries? What share of the economy’s output should they represent? Such definitions would be incredibly arbitrary or very context dependent.

The reality is that the reason many use the fallacious rule is because all other alternatives seem worse. Thus, politicians and pundits who try to downplay talk of a recession by mentioning an imperfect rule may be politically, not economically, minded.

Vincent Geloso

Vincent Geloso

Vincent Geloso, AIER Senior Fellow, Associate Professor of Economics at Queen’s University College. He received his PhD in economic history from the London School of Economics.

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