Monday, May 4, 2009

What can we learn from past recession-recovery cycles?

Not much, unfortunately. This post began as an attempt to replicate a recent Macroeconomic Advisers (MA) research note that assessed the potential for a strong US recovery based on Milton Friedman’s plucking model. In brief, Friedman hypothesized that the economy was like a string attached to the underside of a upward slanted wooden board, with the board acting as a limit on the rate of growth. In a recession, the string is pulled (or plucked, hence the name) downward creating a gap between actual and potential growth. When the string is released, it will bounce back at a speed proportionate to how far downward it was pulled with the implication that growth in a recovery following a deep recession will be faster than growth following a mild recession.

One problem with trying to replicate the MA study is the low occurrence of recessions in Canada compared with the United States. As the figure shows, Canada had two very deep and prolonged recessions from 1961 to 2007 and a third that began in 2008 (the broken line represents my forecast to 2010).

To test the plucking theory with Canadian data I have plotted the magnitude of Canadian recoveries in the first 4 quarters after a business cycle trough against the depth of the recession. The plot reveals no consistent pattern for economic recoveries in Canada. Indeed, leaving out the blue square representing my forecast, it would be difficult to draw a meaningful regression line though the points below.

The 1981-1982 recession fits Friedman’s plucking theory – a deep recession followed by a robust recovery. However, the 1990-1991 recession was followed by a tepid recovery while healthy recoveries followed the relatively mild recessions of 1974-1975 and 1980. Though in the latter case the recovery was quickly snuffed out by the onset of the 1981-1982 recession.

It is often said that no two recessions are alike and from the above it would seem that sentiment would apply to recoveries as well. I do find it interesting that, in contrast to the results based on US data, the depth of Canadian recession provides little insight into the magnitude of the eventual recovery. Anyone have a theory why this might be the case?


Edward J. Dodson said...

The driver of the business cycle is the property market (and, more specifically, the land market). In the U.S. the financial system provided credit as the accelerant to a nationwise frenzy of speculative property investment. As property (i.e., land) prices skyrocketed, the primary secondary mortgage market players -- Fannie Mae (my former employer), Freddie Mac and FHA obligingly increased maximum loan limits, reduced down payment requirements and added flexibility to creditworthiness standards. All of this increased the demand side of the property market, driving up prices even higher. The banks and Wall Street by-passed the standard secondary market players altogether by securitizing subprime (and, to a signficant extent, fraudulently originated) mortgage loans that had an expected default rate many multiples of conventional mortgage loans.

The lesson to be learned is that land markets are inherently dysfunctional, made so by upside down tax policies that actually reward land speculation -- low effective rates of annual taxation on land values that result in the capitalization of imputed ground rent into higher and higher selling prices for land, and the treatment of gains on the sale of land as a capital gain, when land is not a capital good we produce.

It is unlikely politicians in the U.S. or Canada will change the tax system to deal with land speculation. Those who profit from the current structure are major campaign contributors. Not enough economists recognize the above problems to form a powerful lobby for real changes in public policy.

One measure that might have a chance is to protect the banks from themselves by prohibiting banks that benefit by government-insured deposits from making loans for the purchase or refinancing of land value. This would remove some of the fuel from property inflation and require purchasers to save to meet reasonable down payment requirements.

Dave said...

Maybe five data points isn't enough to draw any conclusions.

(that's also my no-charge summary of business cycle theory in general).

Shock Minus Control said...

Edward - interesting, though I'm not sure your comments explain much business cycles.

Dave - I agree, as I said in the post, there isn't much to work with in the Canadian recession data (a good thing for everyone but applied macroeconomists)

Phillip Huggan said...

I notice CAD up today. Whether accurate or not, our dollar trades pro-cyclically. When commodities prices go up a little CAD goes up alot. That got me thinking we should be running massive surpluses during economic growth (not cutting high-end corporate and income taxes and GST) to cushion for a falling dollar. With the flight to USD quality in the middle of a USA unleashed Canada recession, we are doubly whammied. For instance our financials should be in a better position to bargain hunt.
During recession, you can do things like increase accelerated capital depreciation allowance for USA-made industrial productivity increasing goods. And especially, you can use the surpluses to diversify away from perceived pro-cyclical commodity economy.
Like you could encourage AB and SK to use natural gas for fertilizer. You could encourage more value-added domestic output like materials science oil chemical companies in AB or more agriculture manufacturing activities. Sell copper plating and pipes, not just raw materials.

This cut taxes in booms and cut taxes in busts misses out on the chance to diversify out of a perceived cyclical currency. If this flight-to-quality is regular, we are double whacked by USA market recession and currency flight. This diversification, which requires surpluses in good times, is something I'd expect an economist to understand.

Phillip Huggan said...

...another applied example, the Winnipeg Mint is the world leader in coin metal plating technology. But they could've be a given some of the Flaherty tax-cuts to diversify to corner daycare, gym, prison, medical equipment products market (and coins) to make anti-bacterial copper (or silver/nickel) platings.
But this government is hostile to Crowns anyway. Above is just one example of how a Canadian Finance department could use its resources at hand instead of depleting them.
Corporate tax cuts go to banks, who are neutral, and oil sands, who are eeeeeevil. The Crowns, who for example protect us from pandemics, are generally good.

Pat said...


So if I understand this the US typically follows the pluck-string model, and Canada is all over the map.

Possible reasons:

1. The US gov't is better at pulling out of recessions than the CDN gov't. You see that now with the US doing the heavy lifting for the world, and countries like Can sitting around waiting.

2. US investors and industry are less risk averse. During a recession CDN investors to some degree think "man that was awful - I am never going there again." US investors are thinking "BARGAINS!" US industries set their sails early for growth, CDN industries wait longer to make the investments (hiring, capital) for the next wave of growth.

Just curious though, do currency fluctuations ($US vs $CDN) mask GDP growth sometimes? If CDN GDP stalls coming out of a recession but the currency value increases relative to the $US is that not an indication of recovery? We see that now with the TSX rising and the $CDN dollar also increasing in value. Both are signs of recovery are they not? Does it make sense to redraw the graph and adjust for currency? Maybe the plucked string would reappear.

I don't think Friedman said the economy was *like* a board and string. He said it *was* a board and string.