A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.



A Golden Opportunity Missed

The economy is now on a recession track. Yet this recession could have been averted.

Envision a large Roman stone column that has just started to topple. At that moment, a modest push back near the top would be enough to right it again. But if its fall gains momentum, it is virtually impossible to stop it from crashing down.

The U.S. economy continued to grow through the end of 2007, but as the New Year began, the column that is the U.S. economic expansion had just begun to tip over.

Make no mistake: The opportunity was there for prompt action in terms of both fiscal and monetary policy to avert this recession. At that juncture, prompt stimulus to boost consumer spending could have made a decisive difference, and policymakers seemed to understand that. The administration and Congress passed a tax rebate package with unusual speed, with officials noting that “time is of the essence.”

Unfortunately, the policymakers concerned may not have understood what that really means, since they were content to let the rebates start reaching consumers several months later, rather than demanding innovative ways to get the stimulus to consumers much sooner, as was needed.

For the purpose of averting a recession, several months is a lifetime—after all, the last two recessions lasted just eight months each. So, despite a unique opportunity, fiscal stimulus is likely to arrive too late to avert a recession.

And only this month, the Federal Reserve Board has finally begun to take aggressive and unorthodox steps to stabilize the housing and credit markets. While such actions met the need of the hour, they are unlikely to have the same impact today as they would have had a few months ago. In effect, an unusual opportunity to avert a recession was missed by policymakers.

Why was speed so important? Because, uniquely in this business cycle, premature pessimism created a window of opportunity to right that stone column of the economy before it came crashing down. Normally you'd never get that chance.

Recession expectations have been growing for a long time as Fed rate hikes were followed by oil price spikes, a bursting home price bubble and the subsequent credit crisis. This premature fear of recession caused consumers and businesses to rein in spending, creating the danger of a self-fulfilling recession prophecy. But there is another side to the story.

The biggest negative impetus in any downturn comes from manufacturing, driven mostly by the inventory cycle. Unaware of an approaching recession, businesses typically produce goods in anticipation of rising demand. When, to their surprise, demand for their products starts falling, inventories surge, forcing sharp production and job cutbacks, thus reducing consumer income and spending power. The spending cuts force further production cutbacks to work off the excess inventory.

This time around, the prolonged pessimism about the economy, along with the surprise acceleration in economic growth through last summer, resulted in a sharp drop in business inventories, taking the inventory/sales ratio to a record low. In essence, the long list of “recessionary shocks” that we've experienced since 2005 (Fed rate hikes, oil price spikes, the housing downturn) had most people, including chief executives, expecting a recession, which is most unusual before a recession. As a result, the cupboards were bare, and the manufacturing sector was totally primed for even a modest boost in consumer spending to force it to ramp up production and hiring, reversing the vicious cycle that is recession.

Had timely stimulus resulted in a quick burst of spending, it would have led manufacturers to increase production instead of reducing inventories, and they wouldn't have been able to get the goods from China on such short notice. That is why prompt stimulus could have been unusually potent this time.

Separately, global pessimism about the U.S. economy caused a major decline in the dollar and made U.S. exports much more competitive, bolstering U.S. export growth and further supporting production. The unusual decline in inventories and the boost to exports in this cycle were the paradoxical results of widespread pessimism. In that sense, the premature pessimism had the potential to culminate in a self-negating prophecy of a recession.

It was not to be. The process of spreading weakness that leads to recessionary job losses is now under way, and it is too late to head off the recession.

Some will rightly argue that recessions are cathartic, and that to try to avert a recession with stimulus is essentially rewarding the bad behavior of those contributing to the housing and credit bubbles. Perhaps, but we must also recognize that recessions bring with them collateral damage affecting millions of innocent bystanders.

The bottom line is that the outcome was not preordained. Policymakers had a choice about the speed at which stimulus took effect. If they had understood this, their actions could indeed have averted this recessionary downturn.