Calling it a Recession
Ka-fu Wong
School of Economics and Finance
University of Hong Kong
** Prepared for the Professional Development Seminar for Economics Teachers, October 21, 2009.
1
Outline
Definition of business cycles
Why do we care about business cycles
Causes of business cycles
Business cycles dating
 NBER, e.g., US
 Shiskin Rule, e.g., HK
 Hong Kong’s dependence on US
 Causes of the recent financial crisis and recession




2
Definition of Business Cycles
A cycle consists of expansions occurring at about the same
time in many economic activities, followed by similarly general
recessions, contractions, and revivals which merge into the
expansion phase of the next cycle; this sequence of changes is
recurrent but not periodic; in duration business cycles vary
from more than one year to ten or twelve years; they are not
divisible into shorter cycles of similar character with amplitudes
approximating their own.
(Burns and Mitchell, 1946, p.3)
Burns, A.F., and W. C. Mitchell (1946), Measuring Business Cycles. New York: NBER.
3
Definition of Business Cycles
 The term business cycle (or economic cycle) refers
to economy-wide fluctuations in production or economic
activity over several months or years.
 Expansion (or boom) episode: from local minimum
output to maximum output, i.e., from trough to peak
 Contraction (recession) episode: from local maximum
output to minimum output, i.e., from peak to trough
4
100
95
90
Output Level
105
110
Definition of Business Cycles
0
50
100
Time
150
200
5
Definition of Business Cycles
100
95
90
Output Level
105
110
R
0
50
100
Time
150
200
6
100
105
110
output level
115
120
What if …
0
50
100
Time
150
200
7
Alternative Definition of Business Cycles
 Deviations of output from trend
 Also known as growth cycles or deviation cycles.
 Expansion (or boom) episode: output grows at a higher
rate than the trend.
 Contraction (recession) episode: output grows at a
lower rate than the trend.
8
115
110
105
100
95
output level
120
125
130
Alternative Definition of Business Cycles
0
50
100
Time
150
200
9
0
-5
-10
output level
5
10
Alternative Definition of Business Cycles
0
50
100
Time
150
200
10
0
-5
-10
output level
5
10
Alternative Definition of Business Cycles
0
50
100
Time
150
200
11
115
110
105
100
95
output level
120
125
130
Alternative Definition of Business Cycles
0
50
100
Time
150
200
12
110
105
100
output level
115
120
Alternative Definition of Business Cycles
0
50
100
Time
150
200
13
110
105
100
output level
115
120
Alternative Definition of Business Cycles
0
50
100
Time
150
200
14
Alternative Definition of Business Cycles
 Difficulty:
 We need to define and estimate the trend before we can
conclude about the business cycles
 Trends:
 Linear trend
 Quadratic trend
 Stochastic trend
 Filtering out the high-frequency fluctuations and the low-frequency
fluctuations using some advanced statistical technique, known as
Band Pass Filter.
15
US Industrial production index, levels
Stock and Watson (1998, Fig. 1.1)
16
Estimate of the cyclical component of US
industrial production index
Stock and Watson (1998, Fig. 1.2)
** A bandpass filter was used to isolates fluctuations at business cycle periodicities, six quarters to eight years.
17
Macroeconomics is about business cycles
 The explanation of fluctuations in aggregate economic activity is
one of the primary concerns of macroeconomics.
 The most commonly used framework for explaining such
fluctuations is Keynesian economics. In the Keynesian view,
business cycles reflect the possibility that the economy may reach
short-run equilibrium at levels below or above full employment.
 Recessionary gap: the economy is operating with less than full
employment, i.e., high unemployment
 Expansionary gap: the economy is operating with more than full
employment, i.e., low unemployment
18
Economic expansion or recession?
Price
Level
(P)
a. Expansion
b. Recession
c. Cannot be determined
SRAS
P
AD
0
Y
Quantity of
Output (Y)
19
Expansionary or Recessionary (I)
Price
Level
(P)
LRAS
SRAS
a. Expansionary gap
b. Recessionary gap
P
AD
0
Y*
Y
Quantity of
Output (Y)
20
Expansionary or Recessionary (II)
Price
Level
(P)
LRAS
SRAS
P
a. Expansionary gap
b. Recessionary gap
AD
0
Y
Y*
Quantity of
Output (Y)
21
Recession
 A recession is a general slowdown in economic activity over a
long period of time, or a business cycle contraction. During
recessions, many macroeconomic indicators vary in a similar way.
 Production falls
 Gross Domestic Product (GDP),
 employment,
 investment spending,
 capacity utilization,
 household incomes,
 business profits and
 inflation
 Bankruptcies and the unemployment rate rises.
http://en.wikipedia.org/wiki/Recession
22
Why do we care about business cycles?
 While we may love expansion but we would not want to
experience recession.
 Most of us are risk averse and prefer stable income
 Implications for policy makers
 A good understanding of the cycles helps us prevent
it or reduce the magnitude of the cycles.
 Implications for individual consumers and investors
 A good understanding of the cycles helps us predict
the cycles and hence prepare for the cycles.
23
Predictors of a recession
 In the US a significant stock market drop has often preceded the
beginning of a recession.
 Inverted yield curve uses yields on 10-year and three-month
Treasury securities as well as the Fed's overnight funds rate.
Another model developed by Federal Reserve Bank of New York
economists uses only the 10-year/three-month spread. It is,
however, not a definite indicator; it is sometimes followed by a
recession 6 to 18 months later.
 The three-month change in the unemployment rate and initial
jobless claims.
 Index of Leading (Economic) Indicators (includes some of the
above indicators).
 Lowering of Home Prices. Lowering of home prices or value, too
much personal debts.
24
Causes of business cycles
 The cause of a business cycle typically is taken to be a
shock or innovation to a relationship in the economy.
 Only deviations from the rule then would be admissible
as a shock.
 Shocks are defined according to specific models.
http://www.bos.frb.org/economic/conf/conf42/con42_03.pdf
25
Example of shocks
 An elementary open-economy model:
 an augmented IS-LM model or Mundell-Fleming model.
 The model distinguishes domestic and foreign shocks as well as
real and monetary shocks.
 This level of abstraction and general orientation of underlying
assumptions about the economy is typical of the historical literature
on business cycles in the United States.
Domestic
Foreign
Real
DR
FR
Monetary
DM
FM
http://www.bos.frb.org/economic/conf/conf42/con42_03.pdf
http://en.wikipedia.org/wiki/Mundell-Fleming_model
26
Recessionary gap
Price
Level
(P)
LRAS
SRAS2
SRAS1
P2
B
A
P1
Higher price
Lower output
Lower employment
Higher unemployment
AD1
0
Y2
Y1
Quantity of
Output (Y)
27
Recessionary gap
Price
Level
(P)
LRAS
SRAS1
A
P1
B
P2
Lower price
Lower output
Lower employment
Higher unemployment
AD2
0
Y2
Y1
AD1
Quantity of
Output (Y)
28
Expansionary gap
Price
Level
(P)
LRAS
SRAS1
Higher price
Higher output
Higher employment
Lower unemployment
B
P2
A
P1
AD1
0
Y1
Y2
AD2
Quantity of
Output (Y)
29
Expansionary gap
Price
Level
(P)
LRAS
SRAS1
SRAS2
A
P1
B
P2
Lower price
Higher output
Higher employment
Lower unemployment
AD1
0
Y1
Y2
Quantity of
Output (Y)
30
Business Cycle Dating in the US
 The National Bureau's Business Cycle Dating Committee
maintains a chronology of the U.S. business cycle. The
chronology identifies the dates of peaks and troughs
that frame economic recession or expansion. The period
from a peak to a trough is a recession and the period
from a trough to a peak is an expansion.
 The NBER does not define a recession in terms of two
consecutive quarters of decline in real GDP. Rather, a
recession is a significant decline in economic activity
spread across the economy, lasting more than a few
months, normally visible in real GDP, real income,
employment, industrial production, and wholesale-retail
sales. http://www.nber.org/cycles.html
http://www.nber.org/cycles/recessions.html
31
Identifying the trough in November 2001
 On July 16, 2003, the committee determined that a
trough in economic activity occurred in November 2001.
The committee's announcement of the trough is at
http://www.nber.org/cycles/july2003.
 On November 26, 2001, the committee determined that
the peak of economic activity had occurred in March of
that year. For a discussion of the committee's reasoning
and the underlying evidence, see
http://www.nber.org/cycles/november2001.
 Thus, March 2001 (peak) to November 2001 (trough)
was a recession.
http://www.nber.org/cycles/recessions.html
32
The committee’s usual procedures in identifying
trough
 Because a recession influences the economy broadly and is not
confined to one sector, the committee emphasizes economy-wide
measures of economic activity. The committee views real GDP as
the single best measure of aggregate economic activity. In
determining whether a recession has occurred and in identifying
the approximate dates of the peak and the trough, the committee
therefore places considerable weight on the estimates of real GDP
issued by the Bureau of Economic Analysis of the U.S. Department
of Commerce.
 The traditional role of the committee is to maintain a monthly
chronology, however, and the BEA’s real GDP estimates are only
available quarterly. For this reason, the committee refers to a
variety of monthly indicators to choose the exact months
of peaks and troughs.
33
The committee’s usual procedures in identifying
trough
 It places particular emphasis on two monthly measures of activity
across the entire economy:
 (1) personal income less transfer payments, in real terms and
 (2) employment.
 In addition, the committee refers to two indicators with coverage
primarily of manufacturing and goods:
 (3) industrial production and
 (4) the volume of sales of the manufacturing and wholesaleretail sectors adjusted for price changes.
 The committee also looks at monthly estimates of real GDP such as
those prepared by Macroeconomic Advisers (see
http://www.macroadvisers.com).
 Although these indicators are the most important measures
considered by the NBER in developing its business cycle
chronology, there is no fixed rule about which other measures
contribute information to the process.
34
Figure 1: Quarterly Real GDP
The fact that this broad and reliable indicator of macroeconomic activity surpassed its previous peak in the
fourth quarter of 2001 was a key reason that the committee felt that the recession that began in March 2001
had ended. … The fact that quarterly real GDP grew very strongly in the fourth quarter of 2001 also helped to
limit the possible months that could be identified as the trough. The committee felt that the recovery must
have begun before December 2001 for GDP to have grown so rapidly in the fourth quarter.
35
Figure 2: Real Personal Income less
Transfers
The behavior of this series is consistent with both the identification of a trough and the placement of the
trough in November 2001. Real personal income fell in early 2001. It reached its low point in October
2001. However, because it grew only a small amount between October and November 2001, the NBER
methodology indicates that it reached its trough in November. Since then, personal income less transfers
generally rose through January 2003, fell in February and March, but rose
in April and May, the most recent reported months.
36
Figure 3: Payroll Employment
The fluctuations in this series are quite different from those in the broader, output-based measures.
Employment reached a peak in February 2001 and declined through July 2002. It rose slightly through
November, took a sharp downturn in December, rose again in January 2003, but since then has declined
through June 2003, the most recent reported month. It is now 394,000 below the start of the year, and
2.6 million below the February 2001 peak. The fact that employment has continued to decline while
output-based measures have risen reflects the fact that productivity has risen substantially since late
2001. The divergent behavior of output and employment was a key reason why the committee waited a
long time before identifying the trough.
37
Why identified November 2001 as trough
with conflicting data?
 The behavior of other monthly series is also consistent with the
identification of the trough in late 2001. Industrial production fell until
December 2001 and then rose rapidly until July 2002. It has fallen slightly
since then.
 Real manufacturing wholesale-retail sales reached its low in September
2001. It then recovered substantially in October 2001, only to fall again in
November. As discussed in the trough announcement, the NBER
methodology holds that extreme events, such as strikes and natural
disasters, that affect particular monthly observations should be
downweighted in identifying business cycle turning points. For this reason,
the committee emphasized the November 2001 trough in this series,
rather than the dramatic decline in sales following the tragic events of
September 11th. This series has generally risen since September 2001. It
fell sharply in February 2003, but rose substantially in March, the most
recent reported month.
 The committee also looks at monthly estimates of real GDP provided by
Macroeconomic Advisors. This series reached its low in September 2001
and has generally been growing since then. The fact that monthly GDP
rose dramatically in December 2001 reinforced the committee’s decision
that the trough occurred in November. Monthly real GDP fell slightly in
March and April 2003, the most recent reported months.
38
NBER recession dates
http://www.nber.org/cycles.html
Peak
Trough
Contraction
Expansion
Cycle
P-P
T-T
August 1929(III)
March 1933 (I)
43
21
64
34
May 1937(II)
June 1938 (II)
13
50
63
93
February 1945(I)
October 1945 (IV)
8
80
88
93
November 1948(IV)
October 1949 (IV)
11
37
48
45
July 1953(II)
May 1954 (II)
10
45
55
56
August 1957(III)
April 1958 (II)
8
39
47
49
April 1960(II)
February 1961 (I)
10
24
34
32
December 1969(IV)
November 1970 (IV)
11
106
117
116
November 1973(IV)
March 1975 (I)
16
36
52
47
January 1980(I)
July 1980 (III)
6
58
64
74
July 1981(III)
November 1982 (IV)
16
12
28
18
July 1990(III)
March 1991(I)
8
92
100
108
March 2001(I)
November 2001 (IV)
8
120
128
128
December 2007 (IV)
73
81
39
Suggested exercises
 Go through the NBER’s Business-Cycle Dating Procedure in class.
 Exercise #1: Give students some US data up to different point in
time (available at the St. Louis Fed,
http://research.stlouisfed.org/fred2/). Let them work in groups and
determine the most recent trough or peak.
 Exercise #2: Give students some Hong Kong data up to certain
time (available at
http://www.censtatd.gov.hk/hong_kong_statistics/index.jsp). Let
them determine the most recent trough or peak.
** Re-label the dates if we are concerned that students may remember
the recession dates previously identified by the official announcements.
40
Shiskin’s Rules of Thumb for Spotting a
Recession (two-quarter rule?)






Real GDP declines for two successive quarters
Industrial production declines for a 6-month period.
Real GDP declines by at least 1.5%
Payroll employment declines by at least 1.5%
At least two-point rise in unemployment rate
For six months or longer, less than 25% of the industries are
expanding when measured by the employment diffusion index
using 6-month spans.
 The Bureau of Labor Statistics employment diffusion index
covers 274 industries and asks this question: What share of the
industries are enjoying an employment expansion or
experiencing a contraction? A reading of 50 indicates exact
balance. Values below 50 indicate contraction.
41
5
0
-5
Percentage
10
15
Hong Kong Recessions
Year-on-year Growth rate of Real GDP (chained)
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
Time
42
HK recessions
Unemployment rate 1981:10 - 2009:09
2009:08
2009:09
SA
5.4
5.3
NSA
5.8
5.6
43
Hong Kong’s dependence on the US
 Monthly seasonally adjusted unemployment rate from
1981 October to 2009 August is obtained from the
online statistical tables of Hong Kong Census and
Statistics Department, a total of 335 observations.
 The data are plotted with NBER recession dates.
44
Hong Kong’s dependence on the US
2
4
Percent
6
8
Hong Kong Unemployment Rate
1981:10 - 2009:8
1985
1990
1995
2000
2005
2010
45
Hong Kong’s dependence on the US
 Hong Kong’s unemployment rate tend to increase
during episodes of US recessions. The negative impact
of the US recession or downturn on Hong Kong takes a
couple of months to realize.
46
Understanding recession
 We have to understand expansion
47
How do bubbles cause cycles?
Higher asset prices
Consumption increases
due to wealth effect
Aggregate demand increases
Output increases
48
How does excess liquidity cause a boom?
Excess liquidity and easy credit
Higher asset prices
Consumption and
investment increase
Consumption increases
due to wealth effect
Aggregate demand increases
Output increases
49
Causes of the financial crisis?
Influx of
Foreign Money
Low interest rates
Easy credit
market
Great demand for
Financial products
High consumption
Unprecedented debt
load
•Property
appreciation
•easy initial
terms & ARM
Financial
Bubbles
Housing
bubbles
•Free cash from
refinancing
SEC relaxed capital rule prompted
banks take on higher leverages.
Encouraged subprime mortgages,
incl. Fannie Mae & Freddie Mac.
Mortgagebacked, highly
leveraged,
complex & hardto-value
financial
innovations e.g.
MBS, CDO, CDS
Kept derivatives market
unregulated.
U.S. Govt.
Underestimated the impacts of
shadow banking systems, i.e.
investment banks and hedge funds,
which lacked financial cushions.
Accounting practices allowed
commercial banks to move new
financial products off balance sheets
as complex legal entities.
50
A note on the financial innovations
 Subprime lending means lending towards those borrowers with weak
credit histories; thus it has greater risks of loan defaults.
 Mortgaged-backed securities (MBS) are securities derive their values from
mortgages payments and housing prices.
 A Collateralized Debt Obligation (CDO) bundles cash payments from
multiple mortgages or other debt obligations into a single pool, from which
the cash is allocated to specific securities in a priority sequence.
 A Credit Default Swap (CDS) involves an insurance party, such as AIG,
receiving a premium in exchange for a promise to pay money to party A
(say an investment bank) in the event of party B (mortgage holder)
defaulted.
The risks inherent with the above financial derivatives were not
accurately measured nor reflected by the issuers and rating agencies;
nor fully understood by the investors.
51
How bubbled were the Housing
Bubbles?
 Price of a typical American house increased by 124% from 1997 to
2006.
 U.S. home mortgage debt to GDP ratio increased from 46% in
1990s to 73% in 2008.
 The value of U.S. subprime mortgages was estimated at $1.3
trillion as of March 2007. It spiked to 20% of all mortgages in
2005 from 10% prior to 2004. Delinquency rates increased from
10-15% before 2006 to 25% in early 2008.
 As of Aug., 2009, 9.2% of all mortgages outstanding were either
delinquent or in foreclosure.
52
How bubbled were the financial
Bubbles?
 Between 1996 and 2004, the USA current account deficit increased
by US$650 million, from 1.5% to 5.8% of GDP.
 The top five U.S. investment banks, plus Fannie Mae and Freddie
Mac, were estimated to have US$9 trillion in debt or guarantee
obligations in 2008. These shadow financial institutions were not
subject to the same depository banking regulations.
 The top four U.S. commercial banks were estimated to have to
return between US$500 billion to US$1 trillion to their balance
sheets in 2009.
 Volume of CDS outstanding increased 100-fold from 1998 to 2008,
estimated at US$33 to $47 trillion as of Nov., 08.
53
Financial markets impacts (1)
 Troubled banks were nationalized (Northern Rock) or acquired
(Merrill Lynch), if not gone bankrupt (Lehmann Brothers).
 The credit markets were paralyzed, so the U.S. government had to
extend insurance for the money market accounts. A $700 billion
emergency bailout program, Troubled Asset Relief Program (TARP),
was signed into law in October, 2008 to stabilize the economy.
 It was estimated that Americans on average lost more than one
quarter of their collective net worth from mid 2007 to late 2008,
resulting from declines in consumption and business investment.
54
Financial markets impacts (2)
 The U.S. financial crisis rapidly spilled over and many European
banks failed. The de-leveraging of financial institutions further
worsened the liquidity crisis. Although Asia was not at the center of
the financial crisis, weakened economies in the west caused a
drastic decrease in international trade.
 For the 1st quarter of 2009, the GDP declined by 14.4% in
Germany, 15.2% in Japan, 7.4% in the UK, 9.8% in the Euro,
21.5% in Mexico and 6% in the U.S.A. The unemployment rate in
the U.S. was 9.5% by June 2009.
55
Short-term government remedies
 To avoid a global recession, collective actions were
taken by many governments, including:
 Interest rates were at historical low
 Injected liquidity into the credit markets
 Purchased trillions of government debts and troubled
private assets from banks
 Raised the capital of the national banks by
purchasing newly issued preferred stock in major
banks.
56
The current US recession
 When did the current recession start?
 http://www.nber.org/cycles/dec2008.html
 Has the recession ended?
57
Identifying the quarter of peak
 The product-side estimates fell slightly in 2007Q4, rose slightly in 2008Q1,
rose again in 2008Q2, and fell slightly in 2008Q3. The income-side
estimates reached their peak in 2007Q3, fell slightly in 2007Q4 and
2008Q1, rose slightly in 2008Q2 to a level below its peak in 2007Q3, and
fell again in 2008Q3. Thus, the currently available estimates of quarterly
aggregate real domestic production do not speak clearly about the date of
a peak in activity.
 Other indicators reached peaks between November 2007 and June 2008:
 real personal income less transfer payments,
 real manufacturing and wholesale-retail trade sales,
 industrial production, and
 employment estimates based on the household survey.
 The decline in economic activity in 2008 met the standard for a recession
http://www.nber.org/cycles/dec2008.html
58
Identifying the Month of the peak
 Payroll employment, the number of filled jobs in the economy based on
the Bureau of Labor Statistics survey of employers, reached a peak in
December 2007 and has declined in every month since then.
 An alternative measure of employment, measured by the BLS household
survey, reached a peak in November 2007, declined early in 2008,
expanded temporarily in April to a level below its November 2007 peak,
and has declined in every month since April 2008.
 Real personal income less transfers peaked in December 2007, displayed a
zig-zag pattern from then until June 2008 at levels slightly below the
December 2007 peak, and has generally declined since June.?
 Real manufacturing and wholesale-retail trade sales reached a well-defined
peak in June 2008.
 Industrial production peaked in January 2008, fell through May 2008, rose
slightly in June and July, and then fell substantially from July to
September.
http://www.nber.org/cycles/dec2008.html
59
NBER recession dates
http://www.nber.org/cycles.html
Peak
Trough
Contraction
Expansion
Cycle
P-P
T-T
August 1929(III)
March 1933 (I)
43
21
64
34
May 1937(II)
June 1938 (II)
13
50
63
93
February 1945(I)
October 1945 (IV)
8
80
88
93
November 1948(IV)
October 1949 (IV)
11
37
48
45
July 1953(II)
May 1954 (II)
10
45
55
56
August 1957(III)
April 1958 (II)
8
39
47
49
April 1960(II)
February 1961 (I)
10
24
34
32
December 1969(IV)
November 1970 (IV)
11
106
117
116
November 1973(IV)
March 1975 (I)
16
36
52
47
January 1980(I)
July 1980 (III)
6
58
64
74
July 1981(III)
November 1982 (IV)
16
12
28
18
July 1990(III)
March 1991(I)
8
92
100
108
March 2001(I)
November 2001 (IV)
8
120
128
128
December 2007 (IV)
73
81
60
Additional readings about the crisis
 The Federal Reserve Bank of St. Louis maintains an excellent website
about
 The recent Financial Crisis (http://timeline.stlouisfed.org/):
 The Financial Crisis: A Timeline of Events and Policy Actions
 The Financial Crisis: Glossary
 the current global recession (http://research.stlouisfed.org/recession/)
 the US data (http://research.stlouisfed.org/fred2/)
 Slightly more technical papers:
 Caballero, Ricardo, J. and Pablo Kurlat (2009): “The “Surprising” Origin
and Nature of Financial Crises: A Macroeconomic Policy Proposal,”
Paper presented at the Jackson Hole Symposium on Financial Stability
and Macroeconomic Policy, August 20-22, 2009.
 Taylor, John B. and John C. Williams (2008): “A Black Swan in the
Money Market,” Federal Reserve Bank of San Francisco, Working Paper
2008-04.
61
Additional reading on Business Cycles
 The National Bureau of Economic Research keeps the past announcement
of the business cycle dating
 Peak and trough dates and announcements:
http://www.nber.org/cycles.html
 An illustration of the NBER Recession Dating Procedure:
http://www.nber.org/cycles/recessions.html
 Niemira, Michael P. and Philip A. Klein (1994): Forecasting Financial and
Economic Cycles, John Wiley & Sons, Inc.
 Cotis, Jean-Philippe, and Jonathan Coppel (2005): “Business Cycle
Dynamics in OECD Countries: Evidence, Causes and Policy Implications,”
Paper presented at the Changing Nature of the Business Cycle, the
Reserve Bank of Australia Economic Conference, July 11-12, 2005.
 Temin, Peter (1998): “The Causes of American Business Cycles: An Essay
in Economic Historiography,” NBER Working Paper 6692.
 Stock, James H. and Mark W. Watson (1998): “Business cycle fluctuations
in U.S. macroeconomic time series,” NBER Working Paper 6528.
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