Readers who are knowledgeable about Sherlock Holmes stories know that in one of them, an important clue is that a dog didn’t bark. Well, we in the economics profession have experienced our own “non-barking dog” --- the recession of 2023. It appears that many economists wrongly predicted a recession in 2023 and that fact was duly noted in the media when we ended the year with not merely a positive growth rate (3.1%) but a surge in job creation over the last few months that beat all expectations.
[See, for example: Scott Horsley, “Many experts feared a recession. Instead, the economy has continued to soar,” National Public Radio, January 25, 2024, available here.] The story of the erroneous predictions and what actually occurred in our economy over the past 12 months is an important one --- It demonstrates the fallibility of forecasting. It also demonstrates that many economists have blinders on. They are very good at “predicting the past.” (That means, that whatever happened in the past becomes the template for predictions about the future. In some cases, such an approach works. The earth turns on its axis all the time so predictions that there will be a “sunrise” tomorrow are sure things! But in economics where human beings are involved, not just the earth, sun and moon, it ain’t so simple.) Let’s start with some definitions. Over time economies like ours grow in spurts which are periodically interrupted. The spurts and interruptions constitute the ups and downs of the business cycle. The down part is called a recession. When the economy hits bottom it’s called the trough. After a spurt of prosperity (called an expansion) the transition from up to down (from expansion to recession) is called the peak.
So why were so many economists predicting a recession? Well, it goes like this. There was unacceptably high inflation in 2021 and 2022. (It summed to about 13 percent over the two years). The usual “medicine” the US Central Bank (the “Fed” that reporters always write about) prescribes to beat down inflation is to raise interest rates to slow the economy --- and in particular to increase unemployment so wages will stop going up so fast. There have been 12 recessions since the end of World War II and the majority were preceded by increases in interest rates. Over the decades the FED has constantly attempted to achieve what is called a “soft landing,” which means the economy slows, inflation moderates, but there is no recession.
[By the way, the word recession came into the policy-makers lexicon because the original word economists used for the fall from top to bottom of the business cycle was depression. After the American experience with the Great Depression of the 1930s, the policy-makers wanted to make sure there was never another “depression” so when the economy got “depressed” the word recession was used. For the average person, a recession means a lousy economy. For the Business Cycle Dating Committee of the National Bureau of Economic Research (see https://www.nber.org/research/business-cycle-dating) it’s somewhat complicated. Here is part of their explanation from the above website:
“The NBER's definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months. In our interpretation of this definition, we treat the three criteria—depth, diffusion, and duration—as somewhat interchangeable. That is, while each criterion needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another. For example, in the case of the February 2020 peak in economic activity, the committee concluded that the subsequent drop in activity had been so great and so widely diffused throughout the economy that, even if it proved to be quite brief, the downturn should be classified as a recession.
Because a recession must influence the economy broadly and not be confined to one sector, the committee emphasizes economy-wide measures of economic activity. The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.” (end of quote).
At that same website is a diagram of the economy since 1948 with all the recessions shaded in.]
Why would rising interest rates cause a recession? When they go up, some sectors of the economy, especially home buying (and therefore housing construction) as well as big-ticket items, such as automobiles, shrink which then affects the rest of the economy. Speaking more generally, if interest rates are high, then businesses will have to expect higher profits before they decide to make investments. High interest rates mean it will cost them more to borrow the funds they need to make investments OR it will make a financial investment (to get the high interest rate) more attractive than, say, buying new machinery or expanding the size of their store or factory. Many economists looked at the high inflation of 2021 and 2022 and thought a big dose of unemployment would be necessary to cool it.
Well guess what. They were wrong. We actually had a so-called SOFT LANDING last year. Inflation fell to 3.4 percent and unemployment did not go up. The percentage of the population at work held steady at around 60% from May of 2021 to the present.
[Information on the success of the economy and the failures of predictions is here.]
This is extremely good news --- Even the economic reporters on FOX -- which of course would want to make sure their viewers agree with Trump that the Biden economy is a disaster --had to concede that the economy was in great shape. Now this of course does not mean everybody is in great shape. For those working whose wages have not kept pace with inflation, there is a real squeeze on the family pocketbook. And even though inflation has fallen – the 13 percent average price hikes combined in 2021 and 2022 are still up there --- making buying eggs and milk very painful. (Luckily gas prices are down!)
The interesting question is WHY has the economy NOT fallen into a recession despite the high interest rates. I did not want to bore listeners with a whole bunch of numbers when I recorded this but I’ll put some here.
[Anyone whose eyes glaze over when numbers are thrown around is invited to skip the next five paragraphs.]
First of all, the deep dive of the economy occurred in 2020 during the months of January to April (the first quarter and a month into the second). GDP fell 7.9 percent over those months while unemployment more than tripled from 3.6 percent to 13.2 percent.
[The Federal Reserve Bank of St. Louis published a wealth of economic data in easy to manipulate graphical form. For the entry page to all their data (labelled FRED --- for Federal Reserve Economic Data --- go to https://fred.stlouisfed.org)
[All of the following data is available at www.bea.gov. Once there go to the interactive tables and select Gross Domestic Product, Table 1.1.5.]
Between the first and second quarters, total private investment fell close to $550 billion while consumption spending fell more than $1 trillion. The decline in investment and consumption dragged the entire economy down and both investment and consumption reduced their contribution to the economy. Investment as a percentage of GDP fell from 17.5 percent in the first quarter to 16.3 percent in the second. (Consumption fell less but of course it represented a bigger chunk of the economy. That fall was from 66.7 percent of GDP to 66.1 percent.). Because the fears of a collapsing economy were nationwide, for once Republicans swallowed their allergy to high levels of government spending and Congress passed and Trump signed a number of bills dramatically increasing government direct payments to citizens as well as businesses. The result was a rapid recovery. Investment was higher in the third and fourth quarters than it had been in the first and Consumption was higher in the fourth than in the first. At the end of the year, the investment to GDP ratio was over 18 percent and the consumption ratio was 66.9. This set the stage for the next three years.
From 2021 through 2023, the ratio of investment to GDP started at 17.8%, rose to a ratio of 19% at the beginning of 2022, and settled down to 17.8% for the last half of 2023. No drop in investment despite the rise in interest rates. Consumption, which is the most important impetus to the economy as well as a way for businesses to gauge how much to invest over the next few months also stayed high the entire period. It started 2021 at 67.3 percent of GDP, stayed at 68 % or above for the first 9 months of 2022 and remained in the range of 67.6 to 68.2 through the end of last year.
IN SUMMARY --- consumers kept spending and investors kept investing DESPITE the high interest rates.
How come? The way I see it, the gigantic government expenditures to fight the deep COVID induced recession of 2020 (which continued for most of 2021) actually put a lot of money into the pockets of consumers. This permitted many of them to pay down their debt. Thus, they had reserves to keep up consumer spending during the years that prices rose dramatically. Meanwhile, businesses --- many of which fattened their profit margins by boosting prices in 2021 and 2022 --- had plenty of cash on hand to continue investing. THUS, the usual pattern that signals an immanent recession --- falloff in investment, slackening of consumption did not happen.
Here are two other takes on what happened.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20240131a.htm
I would suggest that it’s just too early to tell WHY we had that so-called soft landing.
For the majority of us, 2023 was a good year --- not just for the superrich --- and we should enjoy it while it lasts. In both the 1980s, and 1990s there were almost decades between recessions (1961 – 1970 was only nine years, for those who are nit-pickers) and the Obama – Trump recovery period lasted from 2009 to 2020. Perhaps we are in for a fairly long period of prosperity. More importantly, I think most significant takeaway is that the massive government spending intervention in 2020 actually worked. It is a pity that the very ambitious Build Back Better Bill could not pass the United States Senate during the 2021-2022 session.
Michael Meeropol is professor emeritus of Economics at Western New England University. He is the author with Howard and Paul Sherman of the recently published second edition of Principles of Macroeconomics: Activist vs. Austerity Policies.
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