Expansions Don’t Die of Old Age, They’re Murdered

November 7th, 2016 by

A number of articles have appeared recently, proclaiming that the present economic expansion is “too old” to survive, and will soon die. However, the data since WWII shows that expansions don’t die of old age, they’re murdered.

So, if economic expansions die of unnatural causes, who are the prime murder suspects?

Broadly, there have been two economic eras in US history – Before WWII, and after. The differences are striking, and have compelled present-day economists to adopt a new understanding of economic cycles.

Dead Rally Walking?

Before WWII, classic economic theory held that, the longer an economic expansion lasted, the higher the probability that it would fall into recession. It was thought that imbalances and rigidities in the market would build up to the point where they would kill the expansion, much like the human body loses the ability to fight off disease and infirmities as it ages.

financial-panic

This comparison actually explained economic activity up to the Great Depression quite well. The time period between the end of the US Civil War and the end of the Great Depression (April 1865 – June 1938) lasted roughly 73 years — 878 months, to be exact. In that time, the United States experienced 19 business cycles split between 420 months of recession, and 458 months of economic expansion. The average expansion lasted only 24 months, while the average recession lasted just over 22 months. Basically, the economy rapidly cycled through “booms” and “busts” of nearly equal length throughout this period.

There is little surprise that economists came up with the “expansions die of old age” theory in such an environment. As represented by the red line in the chart below, the data fit.

death-of-expansion

 

WWII Changed The Economy

After WWII, economists began noticing something different about economic expansions. They were lasting much longer, compared to earlier eras. The average post-WWII expansion has lasted 66 months, compared to 24 months before the war.

The US has spent 84.9% of the time between September 1945 through October 2016 in economic expansion, and only 15.1% in recession. This compares to 52.1% and 47.9% during the 73 years from 1865 to 1938.

There were several contributors to this big swing in prosperity. The United States emerged from the Second World War the most powerful economy on the planet by far. Helping Europe and Japan rebuild provided plenty of work for American factories (since there was basically no competition). When factory jobs moved overseas, the US economy pivoted from manufacturing to services and technology.

Backing it all has been a government and central bank that began acting more forcefully to keep the economy on track.  Both fiscal and monetary policy since WWII have been focused on halting downturns in the economy, and if a recession occurs, working to reverse it. This is in contrast with earlier times, when the government only stepped in during economic disasters.

The Immortal Expansion?

The current economic expansion has lasted 88 months and counting, hitting its seventh birthday this past June. Even so, it is still only the fourth-largest market expansion in US history. (The crown goes to the 1991 – 2001 “dot com revolution” that lasted exactly 120 months.)

postwar-expansions(San Francisco Fed)

Glenn Rudebusch’s work at the San Francisco Fed discovered that the modern economic expansion really has to be murdered to end.

According to his calculations the odds of a modern economic expansion ending from one month to the next is about 2%, or around 23% year over year. These odds are independent of the age of the expansions. Based only on age, an 80-month-old expansion has the same survival odds as a 40-month-old one.

These odds are predicated on a Federal Reserve that can spot and ward off economic imbalances before it is too late. Of course, even the best intentions can go wrong. Caroline Baum writes for the Manhattan Institute about how it is ultimately monetary policy that causes or prevents economic turmoil, no matter the manifestation.

The wrong policy at the wrong time can prolong a recession, or even… kill an economic expansion.

Murder Most Foul

killing-bull-market

That statement may seem a bit extreme, but at their root, many common “causes” of recession are really the “effects” of monetary policy. How a central bank reacts to economic shocks can be the difference between a quick, shallow recession (or no recession at all), and a deep depression.

Causes of Death For An Expansion

At a macro level, expansions are killed by a loss of confidence in the economy, and/or the central bank. This leads to a fall in aggregate consumer or business demand, which sends the economy into recession. Central banks can and do play a major part in killing economic expansions, and their weapon of choice is interest rates.

Raising Interest Rates Too Soon:     Raising interest rates before an economy has sufficiently recovered from a recession can snuff out an economic expansion like a candle. The sudden rise in interest rates would reduce aggregate demand, as borrowing costs rose.

inflationRaising Interest Rates Too Late:     Once inflation becomes visible, it is difficult to restrain. The increased cost of borrowing constrains spending, which reduces demand. Employers are reluctant to increase workers’ pay with the costs of business rising, which reduces real wages. This reduces demand, and begins a recessionary spiral. If the central bank raises rates too quickly, it will pop the asset bubbles that its easy money policy inflated.

Lowering Interest Rates Too Soon:    Lowering rates too soon in expectation of a looming recession is the surest way to ignite bubbles in the economy. Critics charge Alan Greenspan with over-reacting to the Asian Financial Crisis and rapidly dropping interest rates before the US economy needed it. The resulting monetary expansion inflated bubbles in dot-com tech stocks and housing, among other sectors.

Lowering Interest Rates Too Late:    The flipside of raising rates too soon is lowering them too late. This happens when a central bank prioritizes defending the nation’s currency and keeping inflation low, at the expense of growing unemployment. Higher unemployment lowers aggregate demand, causing more layoffs, which increases unemployment, which…

This can force the central bank to overreact, and cut interest rates too forcefully. This can lead to more asset bubbles being blown, such as the stock market since the Great Recession. With bond yields near, or at, zero, large institutional investors such as pension funds have been forced into the stock market, driving share prices much higher than normal.

Low/Negative Interest Rates: Weapons of Mass Recession       A central bank policy of ultra-low interest rates for an extended time puts stress on the financial sector. Borrowers take advantage of low rates to bring future purchases forward, shrinking future demand.

But increased borrowing due to lower interest rates can last only so long. Banks, which are subject to more regulation since the subprime mortgage disaster, soon run out of qualified borrowers. Low interest rates mean that the loans the banks do make, bring in less revenue.

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The advent of negative interest rates, once thought impossible, means that banks have to pay the central bank for funds held on account there. Fearing mass deposit withdrawals, banks in Europe and Japan have been eating those charges, instead of passing them on to customers.

That changed this year, when banks started charging large corporate customers to hold funds over a certain amount at the bank. Some pundits believe that it is only a matter of time before negative interest rates will be passed on to consumers with large bank balances. This will of course cause bank runs, leading to bank failures. Fewer lenders will mean fewer loans available.

In the United States, this means that the Fed has two choices: Continue propping up an increasingly fragile stock market bubble, or stop strangling the financial sector. Some analysts say that the Fed missed its chance to raise rates before the economy got into this state.

The question now is, can the Fed walk the tightrope between raising slowly enough to avoid triggering a stock market crash and a new recession, and quickly enough to build an interest rate buffer before the next crisis? All it would take is for oil prices to rise appreciably, and the inflation would come roaring back.

The Fed has put itself in the position to prove once again that economic expansions don’t die of old age, they’re murdered.

Data for this article came from the Federal Reserve Bank of San Francisco (San Francisco Fed) and the National Bureau of Economic Research (NBER)

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.