For the Coming Recession, Hope For the Best, Prepare For the Worst

The Great Recession started seven years ago (December 2007). It seems hard to believe, but could America already be overdue for another? The recently released employment data for December 2014 marks seven years since the prior peak, or 84 months. This is worth noting because the average duration of U.S. business cycles since 1854 is 56.4 months, or just under five years. That's two recession per decade.

Business cycles have moderated in modern times, a pattern that led many observers to wonder if our macro policy managers had created a Great Moderation. This kind of talk was the norm pre-2007. Unfortunately, the very scholars who had the courage and curiosity to examine the trends are the easiest to mock now. Here is one Federal Reserve assessment:

"[T]he business cycle as traditionally described in terms of recession and expansions is dying out. As discussed in the paper, the end of the business cycle has often been declared dead before with embarrassing results."
- Simon Potter, Forecasting the Frequency of Recessions, June 2006

Timing is everything.

Business cycles got longer after 1945, and things moderated even more after the double-dip recession in 1980 and 1981 when Jimmy Carter was president. There were 128 months between the 1981 peak and the 1990 peak (the longest expansion in U.S. history), another 108 months before the 2001 peak, then 81 months before the 2007 peak.

The state of the art in predicting recessions, using real-time data, is defined by highly refined algorithms, a significant improvement on backward-looking subjective assessments done by academic committees. Even so, they are less like forecasts and more like earthquake alarms. They can tell us if a recession is here, now, but not forecast over the horizon. Economists including Jeremy Piger of the University of Oregon and James Hamilton of UCSD have been refining Recession Probability models which say the odds that the U.S. is in a recession right now are 0.3 and 5.0 percent, respectively.

It seems unlikely that this current era, with all of the fragility, uncertainty, and structural change, would be the environment for the longest-ever expansionary period. But that conclusion is hasty and begs the question: Why do recessions occur at all?

Is a recession a correction to an inflated level of economic activity, that is, a bubble? Is a recession a natural pulse of aggregate activity, perhaps a necessary restructuring due to waves of technological evolution? Or is it an unavoidable reaction to man-made shocks, such as oil price spikes or money mismanagement?

If recessions are a correction to bubbly expansions, which hardly seems like the Obama economy, then current muted growth in GDP and payrolls is good news. Cheer up kids, your mom didn't get a raise this year! Not to mention, oil prices are collapsing, not spiking.

Not so fast. What if the existing economy is artificially strong? Is this a bubble?

From a macro policy perspective, there is a stimulus bubble. Stimuli, rather. Two mechanisms a government has to counter a recession - fiscal and monetary - are at full throttle. The era of managing aggregate demand has run to its logical conclusion. Fiscal deficits during the Obama years were one trillion dollars per year, and are forecast by the Congressional Budget Office to go no lower than 469 billion dollars in 2015 before trending inexorably higher in 2016 and beyond. Meanwhile, the Fed is hinting at scaling back the money supply, but the reality is that it set rates as low as possible and is maintaining them still.

To prepare for the next recession, the Congress needs to focus on slowing, if not gradually reducing, expenditures. As for tax policy, it is high time to build in some automatic stabilizers that will cut tax rates (especially payroll) to counter-balance recessionary unemployment as it happens. As for the central bank, announcing and maintaining a credible rule to stabilize interest rates is long overdue.

The message for policymakers is this: hope the best, but prepare for the worst. Are we prepared?