Thursday, July 10, 2008

A recession state of mind 

A couple of economics bloggers are dismissive of comments from former U.S. Senator Phil Gramm, an economist and adviser to the McCain campaign, that we have a recession mentality, but not a recessionary reality.

"You've heard of mental depression; this is a mental recession," he said, noting that growth has held up at about 1 percent despite all the publicity over losing jobs to India, China, illegal immigration, housing and credit problems and record oil prices. "We may have a recession; we haven't had one yet."

"We have sort of become a nation of whiners," he said. "You just hear this constant whining, complaining about a loss of competitiveness, America in decline" despite a major export boom that is the primary reason that growth continues in the economy, he said.

"We've never been more dominant; we've never had more natural advantages than we have today," he said. "We have benefited greatly" from the globalization of the economy in the last 30 years.

Justin Fox wonders how the MSM will react when the advanced second quarter GDP report is released at the end of the month. So do I. Our last quarterly business report showed a very sour future outlook for businesses. When asked for their evaluation of the level of business activity in their own firms for November versus May (when we fielded the survey) to 86 respondents here in the St. Cloud area, 14 said they expected a decrease and 35 said they expected an increase (the remainder unchanged or no response.) Only five expected national business activity to be higher in the fourth quarter.

But Gramm's and Fox's assessment of the actual data we have are correct: There has been so far nothing to point to that you would classify as dating a recession nationally. Jobs are not the only indicator, as you must look at income, production and sales as well. And yet you have this attitude...

And the attitude matters. Many of the newer models of recession forecasting involve using some kind of regime-switching modeling. For the non-time-series-econometricians reading here, these models basically say that the model we use to describe an economy in expansion -- let's call that the normal world, since expansions are much longer than recessions -- and the model we use to describe an economy in recession are different in kind. Something happens, an impulse, that pushes you from expansion to recession, at which point you move from one world to another. That impulse then switches again and moves you back to the normal world. One of the great mysteries of macroeconomic theory is the identification of that impulse. One of these, though, could be one's state of mind. Nouriel Roubini made just this point last December in creating an indicator from searching for the world 'recession' through Google.
This Google New Recession Barometer is of course not a scientific measure of the probability of a recession; but, as far as forward looking indicators are concerned, it is a pretty interesting one for a variety of reasons: 1. it suggests how much media and analysts are concerned about an economic recession; so it is a proxy for the �wisdom of crowds�; 2. recessions can be, in part, self-fulfilling and due to what Keynes called �animal spirits� in the sense that, while weakening economic fundamentals are the crucial trigger of a recession the degree of confidence about the future of consumers, firms, investors is an important determinant of their economic decisions (how much to consume and invest in real capital) and their portfolio decisions (how much to shun risky assets because of increased subjective risk aversion). If consumers and firms become less confident about the future and worry about a coming recession they will behave in ways � cutting consumption and capital spending � that will reinforce such recessionary trends and increase the likelihood that such a recession will take place.
His indicator currently stands at 22,412, versus 2,870 in July 2006 and 5,060 in July 2007. I look at this as part of Dornbusch's [1991] description of an international crisis as containing three elements: vulnerability; awareness; and fear. Roubini's measure might properly be thought of as the awareness. All three of these, Dornbusch said, are a state of mind.
A rereading of crisis literature (or, more properly, �panic� literature) suggests that more emphasis should be given to the psychological element-How do asset market participants perceive or �frame� the events around them and how do they react when �reality� rapidly changes? The sauve qui peut mentality is not fruitfully explored with traditional rational expectation models. (p. 118)
So what snaps that mentality back to the normal state of the world? I don't think we know that.
Gramm can argue, and I think with some merit, that the current state of the world looks closer to the normal state than the recession state. But economic decisionmaking is nevertheless being driven by a mentality that does not see things as normal. And that will hold down economic growth for awhile. Uncertainty about the electoral outcome or the policies of the two presidential candidates plays a role, but that's not the only thing going on now.