Finding the Root Cause of Recessions
The U.S. managed to avoid recession after the financial crisis, but Japan has succumbed to three contractions since 2009. Economic volatility is a key reason for this divergence, and that tells us a great deal about the risk of future U.S. recessions.
During this decade, both the U.S. and Japan have experienced multiple growth rate cycles, which consist of alternating periods of rising and falling economic growth. Japan had four growth rate cycle (GRC) downturns, three of which turned into recessions; the U.S. experienced three GRC downturns, none of which were recessionary. Why not?
In 2011, a Federal Reserve paper estimated the U.S. economy’s “stall speed,” below which it would plunge into a recession. U.S. growth promptly dropped below that threshold, yet no recession followed. So the concept -- which seemed to have worked quite well since the 1950s -- broke down and dropped out of the discourse.
Specifically, that estimate of the economy’s stall speed was 2 percent two-quarter annualized growth in real gross domestic income. In theory, the GDI is equal to real GDP, but is measured differently. While GDP adds up what the economy produces, such as goods and services, GDI sums up incomes, including wages, profits and taxes. The chart shows two-quarter annualized growth in real GDP for Japan (red line) and the U.S. (blue line), along with the 2 percent stall speed estimate.
Most believe recessions are caused by shocks that then propagate through the economy. In contrast, our research shows that endogenous cyclical forces periodically open up windows of vulnerability for the economy, and that, once it is cyclically vulnerable, almost any exogenous shock can easily tip it into recession. Because such shocks tend to arrive sooner or later, an economy’s entry into a susceptible state is almost always followed by recession.
With this in mind, consider the circumstances leading up to Japan’s last three recessions. In 2011, the magnitude 9.0 Tohoku earthquake hit Japan; in 2012, Japanese exports were hit by a Chinese boycott amid the escalation of the Diaoyu/Senkaku Islands dispute; and in 2014, the sales tax was raised for the first time in 17 years in a bid to rein in the burgeoning budget deficit.
In all three instances, Japan was experiencing GRC downturns, following sharp downturns in the growth rate of ECRI’s Japanese Long Leading Index -- evidence that the economy had entered recessionary windows of vulnerability, during which any significant shock would trigger a recession. As a result, Japanese GDP growth, as shown in the chart, has plunged well below zero three times during this period.
In contrast, the U.S. has encountered no comparable shocks during this period. In fact, it dodged a recession even though U.S. Long Leading Index growth fell sharply in 2011, signaling a clear window of vulnerability. In fact, the GDP growth measure shown in the chart fell in the second half of 2012 to the lowest reading ever seen away from a recession -- meaning it was the worst non-recession in U.S. history -- but absent any shocks, growth remained barely positive.
Every U.S. recession since the early 1970s had been triggered by an oil shock, but this time oil prices stayed rock-steady, with volatility plummeting to its lowest reading since 1970 -- when prices had been fixed -- thanks in large measure to the fracking revolution, facilitated by the easy availability of credit. The under-appreciated upshot was a historic plunge in the volatility of U.S. growth, and the avoidance of a recessionary shock. The torrent of liquidity from the world’s central banks -- including the Fed-- has also helped to support asset prices and dampened stock price volatility.
In fact, the volatility of GDP growth since 2011 in the U.S. has been less than half of what it’s been in Japan. Meanwhile, the measure of U.S. GDP growth shown in the chart has averaged 2 percent (spending almost 60 percent of the time below that threshold), whereas Japanese GDP growth has averaged 1 percent (spending 65 percent of the time below the 2 percent mark).
Thus, Japanese trend annual GDP growth has been half that of the U.S., but Japan has experienced more than double the economic volatility. It’s therefore been much easier for growth to drop below zero in Japan.
But what if U.S. economic cycle volatility should rise? Key central banks have been tapering their bond purchases or are planning to do so soon, and the Fed is preparing the ground for the first-ever instance of quantitative tightening. And those are just some of the more obvious developments to watch.
Today, based on our forward-looking leading indexes, U.S. economic growth is just about as good as it gets. If the next GRC downturn brings the economy to a window of vulnerability, the key to avoiding a recession will be both the continued absence of shocks and economic cycle volatility staying way down.
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