Gauging The Next Recession’s Severity

We may be witnessing history in the making. The current cycle of business expansion in the U.S. is poised to become the longest ever recorded in this country. According to the National Bureau of Economic Research, which maintains the government’s official record of U.S. business cycles, the current expansion began in June of 2009 and is now just shy of tying the 120-month record set by the expansion of March 1991 to March 2001. By the time you read this article, the record may have been broken.

So it’s time to celebrate, right?

Some are celebrating. But many are not. The longer the current expansion lasts, the more people become convinced first that it will end soon and second that the inevitable recession following it will be severe.

Today, fear and pessimism seem to reign, likely because of the lingering memories of losses incurred during the 2008-2009 financial crisis. But while the economy may be in a later phase of expansion, there are critical differences between the economic conditions today and the periods before other dislocations. We contend that while a future recession is all but inevitable, its actual severity—as measured by common methods and standards—might be less than what’s feared.

Signal Of Another Recession?

As for the first prediction—that the expansion will end soon—the pessimist camp gained considerable strength on March 22 when the yield on three-month Treasury bills briefly surpassed the yield on 10-year Treasury bonds, representing the first such yield-curve inversion since 2007. Historically, an inverted yield curve has been a reliable predictor of recessions. The Federal Reserve Bank of St. Louis has observed the yield curve since 1982 and notes that the curve inverted before the recessions starting in July 1990, March 2001 and December 2007. Besides the yield curve, other economic indicators, such as slowing corporate earnings, have also stoked concern about another recession.

A Forest Fire Or Just Plucking?

What about the second dire prediction—that the next recession will be severe? Will it be more so because the expansion that preceded it was so long? In a recent paper with an intriguing title, “A Forest Fire Theory of the Duration of a Boom and the Size of a Subsequent Bust,” two prominent economists, Matthew Jackson (of Stanford University) and Pietro Tebaldi (from the University of Chicago), argue that the length of an expansion is, in fact, correlated to the severity of a subsequent recession. During a protracted expansion, they argue, economic imbalances are invariably created and increasingly accumulated. These imbalances grow into larger and larger stockpiles of dry kindling material, and when the next recession occurs, the match is lit. The resulting forest fire is larger because there is more accumulated dry fuel to feed it.

Perhaps. But not necessarily.