On occasion, a pundit will accurately predict a recession. As far as I know, however, no one is able to consistently predict recessions. Why is that?
I thought of this question recently while at a conference in Nashville, where there was a discussion between Paul Krugman and Tyler Cowen. As you’d expect, there were lots of interesting comments. Unfortunately, I lack a transcript, so the following might not be entirely accurate.
Both Krugman and Cowen had noticed some excesses during the housing bubble period, and both seemed to regret that they had not done better at predicting the problems ahead. I also failed to predict the Great Recession; indeed I probably did even worse than they did, not even seeing the excesses in housing. But I don’t worry much about my failure to predict the recession, as I don’t see that as a realistic goal for economists. On the other hand, I’m even more optimistic than Tyler about our ability to prevent recessions with better monetary policy.
Last week, I happened to notice a MRU video on the Chinese economy, done in 2015. In the video, Tyler mentions that China was sliding into a “Great Recession”. He also discusses 5 structural problems with the Chinese economy. In retrospect, China did not enter into a Great Recession, although in fairness their economy did stumble a bit in 2015, and many believe that growth slowed considerably more than what you see in the official data. Nonetheless, China avoided the worst predictions (we’ll have to see how they come out of the current trade war.)
Perhaps Tyler’s pessimism in 2015 related in some way to his chagrin at not anticipating the extent of problems after the US housing bubble. After all, China has recently had some of the same debt-fueled excesses as the US. Indeed if you agree with Kevin Erdmann’s claim that the US in 2006 was not nearly the housing bubble that most people assume (and I do), then the Chinese situation is arguably much worse. So why no Great Recession?
I’m not going to say that the US housing bubble had nothing to do with the Great Recession. Rather I’d claim that it did not cause the Great Recession. The necessary and sufficient condition for a major demand-side recession is bad monetary policy. It’s true that problems in housing and banking helped to throw Fed policy off course, but with a better monetary policy that need not have happened. Instead, the problem could have continued being managed as it was in 2006 and 2007, when housing construction fell very sharply.
This is why it’s so hard to predict demand-side recessions:
1. The Fed basically sets monetary policy at a position where it expects adequate growth in AD.
2. Fed policy generally reflects roughly the consensus of the economics profession.
3. Thus Fed policy is usually not far from what a consensus of the profession expects will lead to appropriate growth AD.
4. This implies that the consensus of the economics profession will generally not forecast a sharp drop in AD, except possibly when at the zero bound—if you believe that monetary policy is ineffective in that situation (I don’t.)
Of course a few individual heterodox economists will occasionally predict recessions. But that’s not really very helpful, as the public has no idea which alternative views to rely on, especially as success in one prediction generally won’t carry over to the next business cycle.
If Tyler did correctly diagnose structural problems with the Chinese economy, why didn’t that lead to a correct business cycle prediction? Because recessions are very different from structural problems. In the early 1930s, the US had perhaps the most structurally sound economy in all of human history, up to that moment in time. China’s economy was a big mess. Yet it was America that had a Great Depression in the early 1930s, not China. Demand-side Great Depressions aren’t caused by structural problems; they are caused by monetary policy mistakes, by excessively tight money. In contrast, severe structural problems cause countries to be very poor, as with China in the 1930s. It’s about levels vs. rates of change.
If you could predict recessions, you could also predict the asset price changes that come with recessions, such as sharp declines in interest rates and equity prices. That would allow you to become rich. It’s simply not realistic to expect the economics profession as a whole to ever be able to reliably predict in a way that would allow economists to market time much better than Wall Street experts. As a result, we’ll never be able to develop macro models capable of predicting demand-side recessions.
And we shouldn’t even try.
Instead, we should think about policy regimes that will tend to stabilize expected NGDP growth at roughly 4%, even when there are shocks to industries such as housing and banking. What would that regime look like?
PS. This was the first time I had met Paul Krugman in person. I just had a few minutes to speak with him, and mentioned that I thought his 1998 Brookings paper would end up being the most important macro paper of the past 25 years. (I thought I ought to say something positive, after frequently criticizing him in my blogging. But I really do think it’s an extremely important and underrated paper, for reasons explained in this post.)
PS. Just to be clear, I agree with those who say China has some major debt-fueled distortions, and I also believe that this may make it more difficult for Chinese monetary policymakers to avoid a demand-side recession. I don’t know when their next recession will occur.
READER COMMENTS
Ahmed Fares
Oct 14 2018 at 8:09pm
re: a critique of the Sumner Critique
The Fed does not move last. Because there are those other central banks. In a globalized economy, the US no longer has an independent monetary policy.
If the Fed acted independently of other central banks, the value of the US dollar would change such that the Fed would have to reverse its decision.
The US housing bubble was a consequence of low interest rates caused by the global savings glut. Think China here. Had the Fed attempted to hold rates high in an environment of falling global interest rates, the US dollar would have risen against other currencies. A high dollar is recessionary. The Fed would then have had to lower interest rates. Either way, you end up with lower US interest rates. If not in the beginning, then in the end.
US interest rates are made in China.
James
Oct 15 2018 at 12:30am
Since economists are generally not good at predicting economic variables, it is worth considering that they probably cannot even predict the consequences of the policies they endorse. That’s a problem for economists who want to endorse policies on the grounds that those policies will have desirable consequences.
“If you could predict recessions, you could also predict the asset price changes that come with recessions, such as sharp declines in interest rates and equity prices. That would allow you to become rich.”
These kinds of remarks do not seem consistent with the realities of reporting cycles. Since economic data are always reported with some delay, you could be great at predicting gdp and unemployment on the day prior to the report and still not have a useful edge in trading financial assets.
The finance guys aren’t super interested in predicting anything anyway. Value investors, momentum investors, etc realize that they cannot predict when value or momentum stock will outperform. They just believe that the returns to value stocks and momentum stocks come from more favorable distributions than other types of stocks.
Scott Sumner
Oct 15 2018 at 1:13am
Ahmed, Not sure how that relates to this post.
James, You said:
“Since economic data are always reported with some delay, you could be great at predicting gdp and unemployment on the day prior to the report and still not have a useful edge in trading financial assets.”
I don’t think that’s what people mean by predicting recessions.
Ahmed Fares
Oct 15 2018 at 1:29pm
Mr. Sumner,
“Ahmed, Not sure how that relates to this post.”
You wrote the following:
“The necessary and sufficient condition for a major demand-side recession is bad monetary policy. It’s true that problems in housing and banking helped to throw Fed policy off course, but with a better monetary policy that need not have happened.”
My reply to that was that the Fed does not control US monetary policy. Interest rates are set by the market, and the market determines the actions of other central banks.
As someone once commented on your blog, the Fed is a “reaction function”. I agree with that.
As an aside, in a balance-sheet recession, monetary policy has no traction. When consumers are hellbent on repairing their balance sheets, a result of that housing crash, there is no level of interest rates or other policy that will get them to spend. QE did help insofar as it helped prop up the stock market, but the effect was very weak.
But I’ll let Ben Bernanke weigh in here…
“Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” —Ben Bernanke
Scott Sumner
Oct 15 2018 at 4:57pm
Ahmed, Don’t confuse interest rates and monetary policy. The Fed has plenty of influence over the supply and demand for base money, which is what matters.
Ahmed Fares
Oct 15 2018 at 10:16pm
Mr. Sumner,
A quote from the Fed regarding the efficacy of using the money supply to control the economy…
“Over some periods, measures of the money supply have exhibited fairly close relationships with important economic variables such as nominal gross domestic product (GDP) and the price level. Based partly on these relationships, some economists–Milton Friedman being the most famous example–have argued that the money supply provides important information about the near-term course for the economy and determines the level of prices and inflation in the long run. Central banks, including the Federal Reserve, have at times used measures of the money supply as an important guide in the conduct of monetary policy.
Over recent decades, however, the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time.” —Board Of Governors Of The Federal Reserve System
The problem with using the money supply as a guide is that the money supply does not distinguish between GDP and non-GDP transactions, like when money is borrowed for financial engineering like stock buybacks in the case of the latter. In that case, the money supply increases without a corresponding increase in GDP. As the money equation (M * V = GDP) shows, velocity declines as it must by arithmetical necessity.
While the Fed is aware of financial engineering, they can not determine the extent by looking at the money supply. Basically they’re flying blind here.
Scott Sumner
Oct 16 2018 at 11:55am
At no time did I ever say or even hint that the Fed should use the money supply as a guide to policy. That would be almost as foolish as using interest rates as a guide to policy.
Kevin Erdmann
Oct 15 2018 at 1:57am
The irony is so deep. So many people, in hindsight, agree that there was a bubble in 2006, and that they should have realized this might deepen a recession. But, the recession was deep because of policy choices made in late 2008 and after. Those policy choices (contractionary monetary policy and deeply contractionary credit regulations) were popular because they addressed what was considered to be a bubble. They seem to have been largely supported by the people who beat themselves up for not having foreseen the consequences of the perceived bubble.
Nobody should feel bad for failing to predict the recession. They should feel bad that they weren’t picketing the treasury when the FHFA increased the average FICO score on approved mortgages by 40 points at a point when mortgage affordability was at historically favorable levels, which is the main reason working class balance sheets were destroyed and construction employment collapsed.
BC
Oct 15 2018 at 3:32am
“If you could predict recessions, you could also predict the asset price changes that come with recessions, such as sharp declines in interest rates and equity prices.”
I think that’s only true if the Fed always follows market signals, which it doesn’t. Asset prices could reflect a market expectation of recession, but the Fed could ignore those prices and cause the recession anyways. Thus, many people could accurately predict recessions but not the asset price changes that come ahead of recessions. One example would be in 2008 when TIPS prices reflected expectations of deflation. One could have correctly predicted below target inflation without having been able to profit from that prediction.
Also, was Japan’s stagnation during the 90s and 00s considered recession(s) and didn’t many economists predict that stagnation? Would that be an example where the central bank did not reflect the views of many leading economists?
I think we can say that the Fed should not be able to predict a recession, just as a driver should not be able to predict his own accident.
Scott Sumner
Oct 15 2018 at 5:00pm
BC, By the time the asset markets were predicting deflation, we were already in recession. I’m talking about predicting before it occurs.
And no, economists have not been able to predict Japanese recessions.
Benjamin Cole
Oct 15 2018 at 11:49am
I wish I had a cite, but my understanding is that the PBOC will buy bad loans from banks from time to time (in huge clumps, nationwide), and did so a few years back. Essentially, the PBOC prints money and bought bad loans. This left the banking system solvent, and China has been below inflation targets. Yes, a bail-out, but worse is having a banking system seize up.
Yes, this “PBOC buys bad debts solution” creates moral hazard and there may be huge amounts of corruption in Sino banks anyway. It is impossible to know, but Sino residents say financial corruption is like beer at a biker’s rally. But who knows? There is no news out of China, only propaganda.
Latest word is Sino consumers are cutting way back.
Yet, exports to US are bigger than ever, and only a portion of total exports go to US. The trade story has been blown way out of proportion—but maybe people believe the hype.
Robert Simmons
Oct 16 2018 at 1:21pm
I agree that no one can reliably predict recessions. However, wouldn’t a model heavily based on various asset prices that gives probabilities of recession at different time frames be useful? Of course, a prediction market for that would be even better….
Bob Murphy
Oct 18 2018 at 11:46am
Scott,
I wish I had chimed in on this earlier; I hope you are still checking the comments. If you get a chance, could you please elaborate on this part of your post?
“Because recessions are very different from structural problems. In the early 1930s, the US had perhaps the most structurally sound economy in all of human history, up to that moment in time.”
The reason I ask is that I think you are conceiving of “structural problem” differently from how Austrians (or Arnold Kling for that matter) are using the term. So my point isn’t to pounce on you, but just to understand what you seem to think we mean when we diagnose recessions that way.
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