How expectations lead to Recession....

Some analysts have come up with an innovative way to judge an upcoming downturn in the economy. They have developed a benchmark that measures the mention of the word ‘recession’ in newspapers and journals. They assume that as the mention of the word ‘recession’ increases in print and electronic media, the chances of a recession in the near term also increases. Besides the heuristic they have developed to predict an upcoming recession, I feel they have also built in a behavioral phenomenon of market expectations. It’s the expectations about economic conditions that contribute to building a consensus among market participants in predicting business cycles. The benchmark index measuring the ‘r’ word is up again and chances of a recession have increased in the near term, at least based on the predictions on this model. In the following few paragraphs I would try and explain what is recession, how it is caused and what are the means to correct it.

Recession is a stage of business cycle when the economy of a particular country as measured by the growth in its GDP falls for two consecutive quarters. Economic activity in an economy is a function of expectations which various market participants like producers, consumers and investors form for near, medium and long term economic conditions. For example if the market participants feel that government is likely to increase interest rates in the future, they have formed expectations of a rate increase. Such expectations and resultant consensus of future economic conditions guides the participants to act based on such expectations. The expectations formed by market participants are thus a very important element of the movements in the business cycle.

Let’s assume a decision by the government (like a rate hike) makes the market participants expect that the economic activity will slow down in the future. The producers are the first to act on these expectations and they start reducing their inventory in expectation of weak economic activity and thus less demand. The slowing of the inventory cycle reduces demand for raw material and other purchases required for the production process. Thus slowdown in purchasing by the businesses is the first visible sign of an economic slowdown. This is the reason purchasing managers index is monitored very closely and its results have implications on the markets. The purchasing managers index measures the expectations of a sample of purchasing managers by asking them about their purchasing decisions in the future.

The slowdown in inventory cycle and reduced demand by businesses is accompanied by reduced labor requirements as the reduced production requires less labor. Some labor is laid off while there is no fresh demand for new labor. Unemployment increases and thus there is a reduced demand from people who have lost their employment or from those who are not willing to work but not finding the work. As the demand lowers further, businesses make another downward adjustment in their production and inventory cycle. Thus production and inventory cycle gets into a vicious cycle with low demand and unemployment. Each acts to push the other down. In such an economic environment the GDP and the rate of growth in GDP starts falling. A continuous fall of GDP growth in two quarters is classified as a recession.

At this stage when recession has set in, low demand and unemployment is pushing down production and a spiral effect is taking place, economic policy action by the government and central is sought to provide impetus to the economy by removing this imbalance of demand and supply. Since recession is caused by lower demand, the best way to prevent it or correct it is to increase demand.

Government intervenes through its monetary and fiscal policy to stimulate demand and thus kick start the economy. The government gives signals to stakeholders of efforts being made for a recovery so that expectations can be formed in the market of a market recovery. Government through its central banks implements the monetary policy in stimulating the demand.

Central bank through its monetary policy cuts the rate at which it lends money to the banks. It also cuts the reserve ratio required by banks to keep minimum funds with itself in liquid forms. Thus more money is available with banks to lend and since the banks can borrow from the central bank at lower rates, they are ready to lend at cheaper rates. Cheap money attracts businesses and consumers, who start want to exploit this opportunity in building assets and increase consumption for future. Thus the availability of cheap money raises stakeholder’s expectations of increase in demand and an economic recovery.

Since the banking system is lending at low rates, they also reduce the interest they give on deposits. This is done to maintain its net interest margin or the net profit it earns while accepting and lending funds. The incentive to save goes down, as the interest rates of deposits falls, but the incentive to borrow is more as the interest rates are also low.

The government also uses its fiscal policy to stimulate demand. It increases the government spending during recessionary times to stimulate demand. Such spending often leads to a hole in the government’s balance sheet and is categorized as a fiscal deficit (excess of expenditure over revenues in the current year). This deficit is plugged by either by the reserves with the government or with foreign investment in the countries assets. Still another way to plug this deficit is by devaluing the currency. Thus a loose fiscal policy compliments monetary policy in stimulating demand.

Thus the businesses take advantage of cheap money and start taking loans at very low rate of interest for investing and expanding its businesses. The consumers too start spending by taking loans to take advantage of low interest rates. The incentive to save is less due to low interest rates on deposits so that money too comes into the system in terms of spending in real estate or investing in assets like equities etc. The demand increases and the economy starts a recovery. As demand increases businesses start to expand production and build inventories. They start increasing wages and hiring more people to increase production. The people gets employment and more wages which increases their purchasing power and thus demand increases even further. At this stage since demand is very robust; prices of goods start increasing. This is because now more demand is competing for the same level of goods and services. Inflation also increases because demand outpaces supply as demand increases more swiftly than the supply. It takes some time for businesses to increase supply, but because of factors listed above demand has already increased.

Increasing inflation makes the value of money less. As the same goods are now pricier so the same quantity of money now buys less. So now the focus of economic policy shifts to containment of inflation as it pinches the consumers. They are able to buy less quantity of goods with the same money or the same quantity of goods with more money as compared to the past. This reduces their demand for products. Increasing inflation also hits producers as their input cost increases. Their profitability depends on their ability pass on the inflation in their input cost to their consumers while maintaining the same level of sales. Increase output cost reduces demand for the products. As demand lowers, expectations of a slowdown and recession start taking shape again and thus the business cycle is back to where it began from.

The central bank has the toughest role in balancing the economy during different market cycles through its monetary policy. The focus of central bank’s policy has been to contain inflation and keep it within ‘reasonable limits’. It chooses interest rate management as its primary tool of monetary policy to make control inflation. The central bank policy statements particularly related to interest rates and thus seen by market participants with such curiosity and interest as these policy statements help the market form expectations of future and we have seen that it’s the expectations that move the markets.

It is pertinent to mention here that it was a sustained fiscal deficit (excess spending) in the case of Greece which has brought it to the brink of a sovereign default. The government has spent more than its revenue on a sustained basis and thus exhausted all its reserves. It has also accumulated huge foreign debt in plugging this hole. The investments made by foreign investors in Greek’s sovereign assets are unsecured and risk a default because of a big fiscal deficit. It is not able to get out of the situation by devaluing its currency as it a member of a economic union (EU) with a unified currency the value of which is determined by the union and not the independent states. The members of EU are getting together to bring a coordinated action as they are attempting to ward off market expectations of a Greek default. They are assuring the market to avoid expectations about sovereign default and a full blown recession which would bring all the major world economies to a slow down or recession. Thus expectations hold the key.