Recession: what are we talking about?

For INSEE, which is responsible for calculating GDP in France, a country enters a recession when said measure of its economic activity declines for two consecutive quarters. By this definition, we then understand why it is so important to follow the quarterly publications issued by the national statistics institute rather than the annual figures.

Let us now be a little more specific about the notion of withdrawal. Can GDP growth below potential or historical growth be considered a downturn, or is there a downturn only when the GDP growth rate is negative (-0.2% for example)? The second option seems to be the one that takes precedence given the definition of the term withdrawal. Contraction would seem more suitable in the first case. In reality, it is above all that we can very well observe a negative growth rate over two consecutive quarters without the annual growth rate being negative.

Evolution of the quarterly GDP growth rate (FRANCE). Source: INSEE

This may sound silly to you, but it isn’t. For some, an economic recession takes place when the growth rate decreases while remaining positive for two or three consecutive quarters. We find this idea in the criteria that the OECD considers to be indicative of a recession. It is then necessary to introduce the relatively complex notion of the output gap.

The recession according to the OECD

The output gap is the difference between the actual output and the potential output of an economy. It is therefore an unobservable variable since it is surrounded by uncertainties. Think of potential output as the maximum output (of goods and services) an economy can sustain without overheating. This potential production can be obtained thanks to the Cobb-Douglas function.

To put it simply, this function is a kind of weighted average of the factors of production such as employment and capital. The expression of the function (and therefore the weight of each of the factors) is the result of econometric work: we retrieve the historical production figures over a period, we select a set of factors that seem more or less less relevant and we let the magic of the math work. A multilinear regression with the least squares method allows us to obtain the weight of each of these factors, weights which are optimal in the sense that they minimize the difference between the real production and the production calculated by the model.

Once the model is built, we are able to calculate the marginal productivity of a factor (also called input). In other words, we can estimate the effect of increasing one unit of this input on the increase in production. It is therefore possible to get an idea of ​​the potential production of an economic zone.

If real output is higher than potential output, the output gap has a positive sign, and moreover increases gradually in a period of expansion, generally accompanied by a fall in the unemployment rate and pressures to the rise in production costs, including wages, and a delayed effect on inflation. On March 11, 2021, the ECB also quoted in its macroeconomic projections that “with regard to inflation, the positive output gap should translate into inflationary pressures in 2022.”

Economic crises are accompanied by a widening of the output gap, but in the negative domain. Actual production is less than what could be produced at full capacity. This reflects insufficient demand and unused capacity.

As you will have understood, the output gap is a variable which inflates and deflates (sometimes which is reversed) and which accompanies the various economic cycles. When this gap widens, up or down, it’s never a good sign. In one case it is overheating, in the other it reflects activity at half mast.

The fact is that the OECD relies on this measure (an approach criticized on many occasions) to identify an entry into a recession phase. Real production at least 1% lower than potential production for a year is one of the criteria on which the organization bases itself to define a recession.

The problem of measuring growth by GDP

I take advantage of this article to add a set of very interesting remarks, which can be found in the article: “Let’s count what really matters” written by Jayati Ghosh and published on on June 16, 2022.

In his paper, Jayati Ghosh shares his opinion on GDP limits. He maintains that measuring the growth of an economy only by the sum of the added value created does not make it possible to capture the way in which wealth is distributed, the importance of social activities, the quality of life and above all the sustainability of the different systems. at the very root of the functioning of the economy. Data which nevertheless seems crucial and which also makes it possible to understand whether GDP growth is healthy.

He cites the pandemic period in particular to highlight the fact that the essential services which have enabled the greatest nations to get their heads above water were largely underestimated in the simple calculation of the gross domestic product. On many occasions, he also takes the example of India which, from an outside perspective and blinded by the GDP, seems to be a growing nation while many elements reveal major societal problems (access to healthy food and the labor market in particular).

With the UN’s High-Level Advisory Board on Economic and Social Affairs of which he is a member, he took up the challenge of Antonio Guterres, Secretary General of the United Nations: to start working seriously to propose alternative measures. Among them, the median salary multiplied by the employment rate, access to a healthy diet, an activity indicator (which would in particular make it possible to capture the activity of men and women who stay at home to take care of household) and carbon dioxide emissions per capita.

The concept of recession in the United States

In the United States, even if some still consider the fall in GDP over two consecutive quarters to be the signal of recession par excellence (like INSEE), the National Bureau of Economic Research (NBER), which officially declares recessions, maintains that these criteria are no longer those on which economic actors must base themselves to identify such an event. The bureau believes that a greater number of factors need to be taken into account.

According to him, recessions lead to a significant fall in industrial activity, GDP, wholesale and retail trade and a sharp rise in the unemployment rate. The office bases this on macroeconomic indicators such as the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, the OECD Composite Leading Indicator (hello OECD) and the study of the yield curve. Finally, real and lagged indicators confirm the transition from a phase of expansion to a phase of recession.

You will note that such a methodology, not fixing precise levels or phenomena, allows NBER to gain in flexibility and to adapt to each potential regression and its set of characteristics which are specific to it. On the other hand, not defining rigorous levels leaves room for interpretation and many debates can emerge if the office is not consistent in its approach.

In February 2020, the NBER announced that the US economic expansion (long cycle) was over. Historically, the economy takes between 6 months and 7 years to return to its cycle of prosperous growth (you will agree, the historical figures do not help us too much to know where the low point is).

And where are we today?

As of this writing, the NBER has not declared the US economy to be in recession. We are therefore, according to them, in an in-between on the long cycle.

If we stick to all the definitions mentioned above (INSEE, OECD, NBER), neither the United States nor the Euro zone have started their phase of recession, which I remind you, is an integral part of long cycles and therefore seems inevitable (I grant you, it does not help us too much to know that).

At the beginning of June in France, Bruno Le Maire publicly declared that he ruled out the risk of recession on our territory for the year 2022. Behind him, a battery of economists in support and this despite the growth rate at -0.2% on the first trimester. This conglomeration of experts is indeed counting on a slight increase in GDP at a rate of around +0.25% per quarter, and this until the end of the year. You will agree, if we stick to the INSEE definition, the declaration of an entry into a recession phase still takes us in the face and economists are playing with fire by ensuring that the risk is averted. .

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