What is a recession?

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Posted by geoffrey on February 26, 2008 at 9:57am in Economy

There has been a lot of nervous hand-wringing over the possibility of a recession in the US economy lately, and I wonder if a good part of the brewhaha doesn't stem from a fundamental confusion about the definition of the term. A recession is a contraction of the economy and is defined as two consecutive quarters of negative growth in gross domestic product (GDP). GDP is a measure of the total value of goods and services produced by an economy over a given period. So, for example, if someone says "GDP grew by 3% this year," that means that the country produced 3% more stuff this year than it did last year. A recession occurs when GDP falls below zero for two straight quarters. Ie, for two straight quarters, the country produces less stuff than it did the previous quarter. To get a sense of how often that happens, the US economy has only experienced three quarters of negative GDP growth in this decade.

Now, notice how nothing in the definition of recession or GDP has anything to do with the stock market. Then consider what people have been saying recently: that the stock market has been suffering because of the sub-prime mortgage crisis, which could in turn, drag the US into a recession. We know this sentiment is utterly meaningless because the stock market has nothing to do with the definition of recession, but maybe there is some association between the stock market and GDP, such that a declining stock market would correlate with a recession.

To test for such a correlation, consider the graph below. I have plotted annualized GDP growth vs. quarterly growth of the S&P for every quarter since 2000. The vertical axis is percentage growth and the horizontal axis is time. The blue bars are GDP and the red are the S&P.

There are a few interesting features to note. First, we have not seen two consecutive quarters of negative GDP growth this decade. Hence, we have not been in recession this entire decade (despite the popular opinion that the bursting of the dot com bubble induced a recession). Second, the S&P is much more volatile than GDP. Hence, it is not such a big deal that the S&P has tumbled 10 percentage points in six months- the S&P experiences 10-point swings all the time. And thirdly, the two series do not seem to track each other at all.

In fact, the correlation between S&P growth and GDP growth this decade is a paltry 0.25. Now, maybe these series correlate on a lag. That is, perhaps negative S&P growth this quarter induces negative GDP growth next quarter. When I correlate GDP with S&P lagged by one quarter, correlation drops to 0.04! That means the lag of S&P is not related to GDP at all!

So, bottom line, if recent history is any guide, the shake-up in the stock market at the end of 2007 and beginning of 2008 should in no way indicate the beginning of a recession.

Does that mean we are not heading into a recession? No. It's just that you can't tell from watching the stock market.

Tags: stock, gdp, recession, market

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Replies to This Debate

Permalink Reply by Geno C on February 28, 2008 at 9:53am: Why don't you forward this on over to Bernanke? And while you're at it, explain that he can't reduce the interest rate below zero.; ▶ Reply to This

Permalink Reply by geoffrey on February 29, 2008 at 12:03am: It would be sweet though- the bank pays you to take a loan.; ▶ Reply to This

Permalink Reply by Christine C on February 28, 2008 at 11:41am: I’m not really up to date on the economic history of Japan, but its starting to feel like I should read up on it--I'm pretty sure they tried to do things which would have the same effect as reducing the interest rate below zero in Japan. Although they had very opposite problems there (eg "excessive" savings and not enough consumer spending to spur the economy, whereas the US has a negative savings rate -- which a negative interest rate will presumable only exacerbate) Also check out the Posner/Becker blog for interesting economics discussions http://www.becker-posner-blog.com/; ▶ Reply to This

Permalink Reply by geoffrey on February 29, 2008 at 12:04am: Thanks for the blog rec. I'll check it out.; ▶ Reply to This

Permalink Reply by yue on March 3, 2008 at 11:08pm: If my memory serves me right, the Japanese had negative inflation for years. It essentially led to negative real interest rates.; ▶ Reply to This

Permalink Reply by Nadav on February 28, 2008 at 6:10pm: Thanks for the definition and the enlightening data analysis. I would point out, though, that the use of "recession" by commentators and the public does not necessarily track the formal definition, as happens frequently. Your observation that the burst of the dot com bubble did not technically qualify as a recession illustrates the point. The economy can experience a lot of hurt without inducing negative GDP growth. In the case of the economic downturn (is that better?) facing us today, I would argue that the potential for real world effects is far greater than in 2000. The drop in home prices, which many argue has only begun, has the potential to wipe out the value of the most significant asset for most Americans. Mortgage defaults and foreclosures have already rendered much of the trillions of dollars in securitized mortgages valueless, or close to it, and the resulting losses to financial institutions have led to a "credit crunch" that could stifle growth for some time to come. Furthermore, a contraction in the financial services sector represents a major blow to one of the cornerstones of our economy, with all the job losses and secondary effects that will surely entail. So in short, by the time this subprime crisis has rippled through the economy, it may very well cause damage large enough to reach your average joe, and not just your average stockholder.
But that's just armchair economics derived mostly from newspaper articles. It's not like I used to work for the Fed or anything.; ▶ Reply to This

Permalink Reply by geoffrey on February 29, 2008 at 12:10am: Touche Nadav. I think you are right. There are plenty of good reasons to believe we are heading into a recession. But I find it pretty interesting that the stock market hardly correlates with economic growth at all. I'm told this is famously true among Economists, but I suspect little known outside of that world. And I'm sure they would hire you at the Fed.; ▶ Reply to This

Permalink Reply by yue on March 3, 2008 at 11:25pm: Stock market is much more volatile than GDP. Animal spirit display a lot of power there. However, a stock value implies people's expectation on a company's future profits or value. Those indices, therefore, to some extent reflect people's expectation on future economy. People's expectation will affect their behavior--consumption, investment, inventory accumulation...Guess, that is why people like to relate stock market performance with economy growth prospect. In that sense, the changes in stock market should proceed changes in GDP if there is any correlation between the two.; ▶ Reply to This