Recession: A Very Useful Indicator

Most people have a good intuitive understanding of first derivatives: you're going up or you're going down, you're going backwards or you're going forwards. It's an important distinction to make, and it's the reason why people focus on the concept of a recession. You look at the first derivative of GDP, and it's either positive – in which case the economy is growing – or it's negative, in which case the economy is in recession. Simple, comprehensible, and clear.

Which of course means there's a gap in the market for economic analysts like Joseph Ellis to come along and make things much more complicated than they need to be:

A recession is generally defined as two successive quarters of absolute decline in real gross domestic product, or GDP. But by the time real GDP is in actual decline, its rate of growth will have been falling from its peak for as long as 18 to 24 months, and typically we will already be deep into a bear market. By this time, business conditions, corporate profits, and the stock market will have been getting progressively worse for more than a year, and it is far too late for businesses and investors to get out of the way. We must literally redefine the economic downturn as beginning when rates of growth peak and begin to slow, as opposed to when the economy is in actual decline.

What Ellis wants, here, is for us to concentrate on the second derivative of GDP, an indicator so obscure it doesn't even have a name. Is the economy increasing at an decreasing rate of increase? Is it decreasing at a decreasing rate of decrease? It doesn't matter, because at that point you've left the intuitive far behind and you're reduced to playing with numbers.

What would Ellis want us to consider an "economic downturn"? Two consecutive quarters of decreasing GDP growth rates? So if the economy grows at 5% one quarter, 4.5% the next, and 4% the one after that, we would then be in an economic downturn? What if it shrank by 1% in Q1, shrank another 0.6% in Q2, and shrank another 0.3% in Q3? Would we then be in an economic upturn?

Besides, Ellis's assertions just don't seem to be applicable to the present situation. No one's entirely sure if we're already in a recession or if we might enter one very soon. But I really don't think we're "already deep into a bear market" – the S&P 500 is less than 4% off its high point, which was reached only a couple of months ago. And as for peak GDP having been 18 to 24 months ago, it might be worth reminding Mr Ellis that in the third quarter GDP grew at 4.9%.

So let's not "literally redefine" anything. The concept of a recession is a very useful one; Ellis's concept of an "economic downturn", by contrast, is fuzzy and more or less useless. And since there are many more "economic downturns" than there are recessions, Ellis's proposal would only serve to exacerbate volatility as people scrambled to "get out of the way" of some nebulous and ill-defined concept.

(Via Zubin)