Economic Perspective: What Are Recessionary Signals?

MARY WALDEN:

“Today’s program looks at recessionary signals. Mike, everyone wants to know when the next recession will occur, but you’ve said many times that economists generally are not very good at predicting the next business downturn. Are there some signs or signals that we can at least look for to warn us of a greater possibility of an oncoming recession?”

MIKE WALDEN:

“Well that’s the big question, whether there are any themes to what’s happening in the economy before a major downturn occurs. And I just finished reading a book that addresses specifically that question, goes back in history and tries to look at what was happening in the economy, particularly in the financial area, before the economic downturn.”

“And the author concluded that the likelihood of a recession increases dramatically when, first of all, you have some new financial product available in the financial sector that investors like and, in hindsight, they overuse. And then secondly, this new financial product doesn’t capture the attention of public regulators who perhaps would have the tools to moderate the use of that financial product.”

“The author says when you have those two combined that gives you a great deal of worry about an oncoming economic downturn. So for example, if we look at the famous Great Depression, the 1929 crash in the stock market. This is when margin buying really began. You have a lot of margin buying, meaning that people could buy stock with very little money down. Also, if you look at the saving-and-loans institutions prior to the downturn of the early 1990s, they were allowed to begin to invest in alternative investment products. And then of course the most recent recession, what we call now the Great Recession, that was preceded by the development of these extremely complicated mortgage investments that no one really understood, and clearly the regulators were not on top of.”

“So the bottom here is that if you are serious about trying to predict when the next downturn will occur, watch the financial market, watch whether there are new financial products being developed that investors like and whether regulators are asleep at the switch.”

Walden is a William Neal Reynolds Distinguished Professor and Extension economist in the Department of Agricultural and Resource Economics at North Carolina State University. He teaches and writes on personal finance, economic outlook and public policy.