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.