Is a Recession in the Offing?

Is the UK economy heading straight for the rocks?  John Weeks is not convinced.  Image via Wikimedia  https://commons.wikimedia.org/wiki/File:StateLibQld_1_101788_Lammershagen_(ship).jpg

Is the UK economy heading straight for the rocks?  John Weeks is not convinced.  Image via Wikimedia  https://commons.wikimedia.org/wiki/File:StateLibQld_1_101788_Lammershagen_(ship).jpg

Brexit Shock?

The most recent quarterly statistics for the UK economy show an increase in quarter-on-quarter GDP growth for the second quarter of 2016 compared to the first (up to 0.6% from 0.4%, or 2.2 and 2.0% on an annual basis).  None-the-less many predict an imminent recession, to strike Britain before the end of the calendar year and perhaps in the current quarter.

The Office of National Statistics preliminary numbers for Q2 were released on 27 July and may be revised downwards later in August (the first estimate covers a bit less than half the sources of GDP).  If that is the case, further falls in the third and four quarters could take GDP growth into negative numbers.

For most commentators the pessimism about GDP growth in the immediate future arises from what might be named “Brexit effects”, various types of anticipated and unanticipated weaknesses exacerbated or created by the vote to exit the European Union.  Release of statistical indices from the market monitoring company Markit Economics seems to verify the pessimism (see the company’s website for detail).

Recessionary Political Agendas

Most media commentators agree that the Cameron government anticipated a “yes” win on 23 June and had no plan should voters not comply.  Also clear is that the new government has no clear “extraction” strategy as yet.  These uncertainties made anxieties about negative economic effects understandable.

However, if leaving the European Union has serious and negative economic consequences for Britain, it is not obvious that these should manifest themselves in the short run; i.e., in 2016 or early 2017.  Also possible is a period of phoney stability that induces complacency before disaster strikes (if it does).  Further, some if not most of the pessimism comes heavily laden with political agendas, which should induce scepticism or at least doubt about imminent recession. 

Those who supported “remain” see recession as the fulfilment of their pre-referendum warnings.  Unlikely as it may seem, opponents of Jeremy Corbyn wave the recession card as a tool in the fight for the Labour Party leadership.  The current party leaders allegedly have no plan to deal with the recessionary disaster already unfolding (though what practical difference it would make is not clear since no Labour politician will making policy before the next election).

Assessing the Recessionary Likelihood

It should be possible even in this politically charged context to address at least the likelihood of a recession in the immediate future.  Assessing what will develop in the longer term is much more difficult to the point of impossible.  In May the Treasury suffered justified ridicule for its bogus projections of the cost of Brexit.

The first step in assessing the likelihood of recession requires defining the term.  The Treasury definition of recession, used almost universally, specifies that the economy have a negative growth rate for two consecutive quarters, and specifies that the measure be the quarter-to-quarter growth rate.  The frequently used alternative measure, comparing the second quarter of 2016 to the same quarter in 2015 (for example) is less likely to produce two consecutive negative values.  Despite its arbitrariness, I use the quarter-on-quarter measure.

Using the common measure, I start by considering whether we should view the recent PMI indicators from Markit Economics as harbingers of recession.  Despite its uncritical acceptance by the media, the PMI is not easily interpreted.  Rarely if ever does a user of it (or Markit itself) point out that this is an ordinal index not a cardinal measure (Investopedia is an exception though it does not use the word ordinal).

The difference between cardinal and ordinal is very practical and easily understood.  Age measured in years is cardinal (a twenty year old has lived twice as long as a ten year old).  GDP growth also falls into the cardinal category – an economy growing at 5% expands twice as fast as an economy growing at 2.5%.  Markit Economics calculated the PMI’s from surveys of businesses in which the respondent has only three possible answers to chose among, “better”, “same” or “worse”

Two companies, one with an increase in orders of 25% and another with a 5% increase would both answer “better”.  This alone renders the PMI’s ordinal.  As a result, changes in the PMI’s indicate no more than “up” or “down”, never how much up or down.  For example, at the end of 2015 the overall PMI for the UK economy declined from about 53 to about 52, and between June and July this year from just over 52 to just over 48, about one index point in the former case and four in the latter. 

Because the PMI is ordinal, we cannot know which decline was greater.  All we know is that more respondents reported “worse” in the latter case.  That does not imply, for example, that the volume of new orders fell more in the latter case than in the former.

The nature of the Markit PMI’s provokes scepticism about the usefulness of the indices as indicators of economic trends (as “leading indicators”).  The two charts below justify that scepticism.  A glance at the first chart suggests that after 2012 quarterly GDP growth and the Markit index may be quite closely related, so that the downturn in the latter in July 2016 may foretell a fall in the former for the third quarter of the year.

The second chart, a “scatter diagram” with PMI vertical and GDP growth horizontal, indicates the opposite, almost no interaction.  A bit of statistical analysis indicates no significant relationship between GDP growth and the PMI over the four years.  A recession may arrive in 2016, but the Markit indices provide no guide (as the Office of National Statistics concluded for the Markit construction index). 

Quarter-on-quarter GDP growth & Monthly Markit Index*, Time series 2012q1-2016q

Quarter-on-quarter GDP growth (vertical) & Monthly Markit Index* (horizontal), scatter diagram 2012q1-2016q2

*Purchasing Managers’ Index for the first month of the current quarter; for example, April 2016 compared to the second quarter of 2016 (April-June). The link for various other possible combinations showed even weaker correlation. Source: Trading Economics and ONS.

*Purchasing Managers’ Index for the first month of the current quarter; for example, April 2016 compared to the second quarter of 2016 (April-June). The link for various other possible combinations showed even weaker correlation.

Source: Trading Economics and ONS.

Finding no help from the much-cited Markit measures, I try a second approach.  GDP expanded in the first two quarters of this year at 0.4 and 0.6 percent.  For the third quarter to initiate recession, growth must drop below zero, a quarter-on-quarter change rate of minus 0.7%. 

The third chart shows GDP growth rates for five and one-half years and the absolute change in the rate from one quarter to the next.  Three years have past since a fall of 0.7 or more between quarters has occurred, from +0.9 to -0.2 in late 2012, immediately followed by an increase of 0.8 percentage points.  Since early 2013 growth rates have shown more stability with no quarter-on-quarter change greater than 0.3 percentage points.

Quarter-on-quarter GDP growth rate & change in growth rate, 2010q1-2016q2

These are not normal times, so past growth stability may be irrelevant to the rest of this year, indeed for years to come.  With little evidence to guide the analysis, a third approach presents itself – what would be the mechanism of a Brexit shock recession, and would that mechanism show its impact this year?

The most commonly proposed mechanism is “loss of confidence”, that the vote to leave the European Union so unsettles the “business community” that the disquiet provokes recession.  However, the recession outcome requires that the drop in confidence (however defined and measured) manifest itself in a decline in aggregate demand – short-term contractions result from businesses not selling all the goods and services they produce.

 In the longer term leaving the European Union may reduce the growth rate of UK exports.  We should not expect the Brexit vote to provoke a short-term drop, because 56% of UK exports flow to non-EU countries, and within the EU British companies will face the same rules as before 23 June.  Quite possible is a momentary increase in exports to the EU as British companies rush to beat the inevitable restrictions to come.

The semi-stagnation of the UK economy during 2010-2013 resulted from the expenditure reduction policies of the late, unlamented George Osborne.  The current government explicitly abandoned the ex-chancellor’s budget targets, even pledging to increase public investment.  I remain sceptical of the government implementing the latter, but expenditure reductions sufficient to provoke recession on their own are not likely.

Expenditure on consumer durables and business investment manifest volatile short term behaviour.  If a recession comes this calendar year, its source will lie in one or both of these.  After recovering to its pre-2008 peak business investment has stagnated, increasing in real terms by less than 1% between the first quarter of 2015 and the first quarter of this year.

The slow recovery of business investment since 2008 implies that it has declined to quite a low proportion of GDP, 10-15% depending on what is included in the measure.  Dragging GDP growth into the negative range this year would require a substantial collapse.  While this is possible, the nature of investment makes it unlikely.  Much of private investment involves outlays over several years.  Only under extreme conditions, such as the 2008-2010 Financial Crisis, do businesses stop suddenly a work in process.  More likely would be cancelling new projects.

Household expenditures on durables can also manifest considerable instability.  They are easily postponed by extending the life of existing appliances.  As for business investment, dropping into recession would require substantial collapse, because durables account for less than 10% of GDP.

Imminent Slowdown but no Recession

In the medium and long term Brexit may inflict its economic revenge, but a recession by accepted definition remains unlikely this calendar year.  More probable is that in the second quarter the GDP growth rate will decline, falling to near zero by the end of the year.

The recent decision of the Monetary Policy Committee to cut the Bank of England rate from 0.50 to 0.25% is a mere gesture with no practical impact on the real economy.  We should view it as a rather transparent attempt to “get retaliation in first”.  In the unlikely event that recession hits this year, the banksters of Threadneedle Street have their defence against criticism in place.

In mid-2010 the first austerity budget of George Osborne brought the recovery of the UK economy to a halt.  The subsequent pursuit of that policy resulted in stagnation and the slowest post-recession recovery on record.  The aftermath of Brexit will make things worse, but unlikely to cause economic havoc to match what the former chancellor and his government achieved through conscious choice.

John Weeks is Emeritus Professor of Economics at SOAS, University of London.  You can follow him on Twitter @johnweeks41