On bonds and bananas

In 1978, a time of globally high inflation, an American economics professor Alfred Kahn annoyed his boss by noting that a failure to get inflation under control would lead to a deep depression.

Kahn’s boss at the time happened to be US President Jimmy Carter. Carter was not amused, and instructed Hahn never to use that word, or ‘recession’ ever again. Kahn, however, was a stickler for plain speaking and was not amused either. At the next press briefing, he used the word ‘banana’ instead of ‘recession’, saying that the US was “in danger of having the worst banana in 45 years”. When the banana industry objected to this terminology, he started using the word ‘kumquat’.

Out of the blue
The point is not that politicians like to put a fig leaf on bad news – we all know they do – but rather that recessions scare people, and understandably as people lose their jobs and businesses go bankrupt. Economies recover in aggregate, but for individuals, these blows can cause lasting damage. But another key reason why recessions are scary is simply that they usually seem to arrive out of the blue. Despite protestations to the contrary, the economics profession has a bad track record of forecasting recessions.

In fact, it can be difficult to even know that a recession is underway. It is usually only with the benefit of hindsight that we know a recession started here and ended there. For instance, the widely-used definition of two consecutive negative quarters of real gross domestic product is problematic for several reasons, but one of them is that the data is released with a long lag.

In the US, the official definition of a recession is set by a committee of experts at the National Bureau for Economic Research and pithily summarised as “a significant decline in economic activity that is spread across the economy and lasts more than a few months”. Sometimes this is called the three Ps – a profound, pervasive and persistent decline in activity. But the NBER Business Cycle Dating Committee only designates recessions long after they have ended, never mind started.

Shocks and seeds
Recessions can be caused by outside shocks, as we saw in early 2020. But usually, the seeds of the recession are sown during the expansion. Households and businesses project the good times deep into the future. They gradually overextend themselves, debt levels rise, sometimes imports rise too much, inflation picks up speed, and the central bank hikes rates in response. One unpredictable day, it is just all too much, and things go pear-shaped.

Companies see pressures on margins, and start cutting back on inventories, staff and expansion plans in order to protect the bottom line. What is rational for one company to do, causes a recession when many companies do it.

As households start seeing job losses around them, they reduce unnecessary purchases, pay off debt and save more. What is a perfectly sensible decision for an individual household to make, cascades into a slump when many households do it.

The cherry on the top is that banks often compound this situation. When times are good, they open the credit taps. When conditions turn, they tighten lending standards and reduce the flow of credit just when the economy requires the opposite.

This process then usually ends through some combination of policy intervention such as interest rate cuts, things becoming cheap enough for bargain hunters to step in, write-downs and write-offs that are painful but free up space on balance sheets, and simply the passage of time that allows for excess inventories to be worked through. Recessions do not last forever, and equity markets usually turn before the economy does.

US matters more
US recessions matter more than any, not just because the US is still the world’s biggest economy, but because of its outsized impact on global financial markets. There is a clear pattern that past global equity bear markets coincide with US recessions (1987 was the notable exception). In recessions, share prices fall because company profits fall. This is compounded by the fact that many investors scramble for cash to make ends meet, and they end up selling what they can – liquid listed equities – not necessarily what they would like to. And of course, the fact that it is all unexpected is what really upsets the apple cart.

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