Defining a recession

The US National Bureau of Economic Research - an academic body which is regarded as the arbiter of American business cycles - defines a recession as “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”.

Significantly, the NBER does not set any great store by the widely quoted proposition that two (or more) consecutive quarters of negative growth in real gross domestic product (GDP) is a necessary and sufficient condition for identifying a recession. The last US recession, in 2001, did not feature consecutive quarters of negative economic growth (real GDP declined in three separate quarters, none of them consecutive); and the current US recession was formally “declared” to have been under way before consecutive quarters of negative real GDP growth had been reported. Indeed, if the NBER had waited until this “condition” had been satisfied before “declaring” that the US was in recession, we would still be waiting for it until this Friday.

Despite this, commentators in Australia and other countries continue to regard consecutive quarters of negative real GDP growth as the defining characteristic of a recession. This can lead to perverse consequences. An unwillingness to acknowledge that the economy is in recession until consecutive quarters of negative growth have been reported is likely to delay the adoption of policies designed to ameliorate its effects - as occurred in the early 1990s when the then government refused to admit that the economy was in recession until some eight months after the recession had begun.

This way of defining a recession also makes no allowance for differences in either population or productivity growth, either over time or across different countries.

In the Australian context, consecutive quarters of negative real GDP growth have been an inaccurate and unreliable guide to whether, and when, the economy has been in recession.

A better approach is to define a recession as a period in which the unemployment rate rises by 1.5 percentage points or more in 12 months or less. This definition is “transportable” across countries and through time; and it accords more closely with ordinary people’s understanding of what a recession actually means.

This definition accurately identifies each of Australia’s recessions since 1960, without giving any “false” signals.

Of course, since unemployment is a lagging indicator, waiting until unemployment has risen by 1.5 percentage points before officially acknowledging that the economy was in recession would be as mistaken as waiting until there had been consecutive contractions in real GDP. But since the unemployment rate has a strong tendency to trend, once an upward trend is underway it would be far more difficult to deny that it was likely to rise by at least 1.5 percentage points than it has been to explain away an isolated negative GDP number.

And this is where Australia now seems to be heading. It is possible that Australia may avoid consecutive contractions in real GDP - although as of this week ANZ no longer thinks so.

Australia will also experience a much larger decline in real income than in real GDP, thanks to the sharp decline in commodity prices which will have occurred by the middle of this year.

And nearly every analyst expects that the unemployment rate will reach at least 6 per cent (that is, 1.5 percentage points higher than last month’s figure) by or before December this year.

The interests of Australian businesses and households might now best be served if we all acknowledged that Australia’s economy almost certainly is now in recession, and focused on the most effective means of dealing with it.

Similarly, it is time to stop pretending that the Budget will remain in surplus, and instead focus on the specific measures by which the budget can be used to support economic activity and employment in the short term whilst also addressing longer-term challenges.

The best possible measures are those which will simultaneously induce an immediate increase in (or prevent declines in) spending and employment, and which will also assist in meeting longer-term goals and challenges.

One-off cash grants such as those which comprised the bulk of last year’s Economic Security Strategy meet the first test but not the second.

Across-the-board personal or business income tax cuts don’t meet either. In the short-term, they are likely to be saved (as were the tax cuts that took effect last July); while unless part of a broader tax reform program will do little if anything to strengthen Australia’s resilience or capacity for growth.

However tax breaks which are conditional on particular types of expenditure - such as a temporary investment allowance for businesses (for example, for capital expenditures undertaken before June 30, 2011), and tax deductions (or cash grants) for household or business expenditures designed to reduce energy or water consumption - will pass both tests.

And if the recession now under way is going to be an extended one, then the usual objections to infrastructure spending (that they do little to alleviate the downturn, but instead put upward pressure on interest rates during the subsequent recovery) lose much of their relevance - especially when there are such obvious and pressing deficiencies in Australia’s infrastructure. In the current climate, increased and accelerated spending on rigorously evaluated infrastructure projects also meet both tests for good policy.