San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Contrived Nature of
the Current Recession (2009)

Here the case is made that the current recession stemmed from the financial crisis brought about by the unexpected declaration of effective bankruptcy of Fannie Mae and Freddie Mac in September of 2008. The immediate effect of this event was serious financial losses by major financial institutions. The impact of the Fannie Mae and Freddie Mac collapses did not have to go beyond the major financial institutions, but it did because it was so momentous that financial investors began to panic. The chain of thought was that if Fannie Mae and Freddie Mac could collapse who knows what other unexpected things could occur and hence it is best to get out of risky investments. A simiar thing occurred when Russia defaulted on its bonds in August of 1998. If a sovereign super power could default who knows what is next. The flight from risky securities in 1998 and 2008 led to a collapse in the value of retirement funds. This in turn resulted in declines in consumer purchases.

The fact that the declines in employment took on a much more serious nature after the financial crisis of September 2008 is demonstrated in the graph of the month-by-month changes in total employment as shown from the Bureau of Labor Statistics data.

There is more to say concerning this display which will be dealt with later. The graph below shows that real GDP did not start declining until after the September crisis.

Technically the real GDP did decline in the third quarter compared with the second quarter but the decline was only 1/8 of 1 percent and the accuracy of the statistics is great enough to say the real GDP actually declined. Moreover whatever decline there might have been could be accounted for as the result of the fading away of the effect of the tax rebate of 2008.

The crucial quantity is business investment in plant and equipment. Such investment is made in anticipation of the need for additional capacity. If business believes that it will not be utilizing the capacity it already has then such investment goes to zero. It would not even be replacing the capital equipment that wears out. Thus business investment in plant and equipment tends to be volatile. However such investment is an important component of aggregate demand, so if it goes to zero then aggregate demand takes a major downturn.

Here is what happened and more importantly what is happening now to private investment in plant and equipment.

This crucial component of aggregate demand is now in free fall heading toward essentially zero. Note that while real GDP is down in 2009I it is still far above its level in 2005I. On the other hand the investment in plant and equipment is in 2009I below what it was in 2005I.

Whereas between 2008III and 2009I real GDP declined by 3.17 % (6.34% annual rate), investment in plant and equipment declined by 16.5 % (33.0 annual rate). The selling off of inventory and not replacing it (negative inventory investment) increased by $74.1 billions between 2008III and 2009I. This $74.1 billion decline in inventory investment along with the $234.1 billion decrease in investment in plant and equipment accounts for 83.2 percent of the $371.5 billion decline in GDP over that period. The decrease in investment in residential housing over the period was $59.5 billion. This amount along with the declines in inventment in plant, equipment and inventory account for 99.2 percent of the decrease in real GDP. There were other declines, such as $46.4 billion in consumer purchases, and some positive influences, such as a decline in net exports of $44.7 billion.

The net significance is that the real recession began in September of 2008. The financial crisis was not so much the cause of it but something that lent credibility the pronouncements that the U.S. economy was in a recession. This led to businesses reducing their investment in additional capacity. This loss in confidence on the part of business is the most serious development. With investment in plant and equipment headed toward zero and businesses selling off inventory and not replacing it the U.S. economy is now facing the crisis that politicians and the media were falsely alleging to be the case last year.

The anti-recession measures promoted by Congress and the President have largely been focused on making sure that the lending institutions have funds to lend. However given the general perception of businesses who would want to borrow to increase capacity under the present circumstances.

In previous recessions the source of the problem was a prior decline in the purchase of equipment and other investment goods. In these current circumstances the level of business investment in plant and equipment was not declining before the third quarter of 2008. It declined only after a barrage of pronouncements that the economy was in a recession and that it was going to to a long one and hence any company that continued to increase its productive capacity would be foolish. Thus in this situation the decline in the production and purchases of automobiles and residential housing was used to induce fear out the part of businesses.

The recession is now real but it was induced by the barrage of pronouncements that the economy was in a recession and that it was going to to a long one. Why was there such insistance that the economy was in a recession long before there was any recession in production. One element was a media hatred for George W. Bush and an obsession with regime-change. Anything that what would destroy the record of the the Bush Administration and help replace it with a Democratic Party regime was looked upon as good, even if it was bad for the country. Crying Recession would not necessarily change the expectations of businesses and their investment plan. It took the dramatic event of the bankruptcy of Fannie Mae and Freddie Mac and the chaos in the financial markets which followed to lend credibility of the pronouncements of recession.

The Timing of the Financial Crisis

Given the crucial role that the collapse of Fannie Mae played in the current recession its placement in September when it would have maximum electoral impact is suspicious. Is it possible that Fannie Mae went bankrupt months before and the announcement was postponed until September? This would have been a terrible thing, but the truth is far worse. Fannie Mae was not bankrupt in early September. Its assets were not less than its liability. Its stock was trading on the stock market. However Fannie Mae's management chose to declare it bankrupt and asked to be taken over by the Federal Government.

This event, precisely because it was unexpected, produced panic in the stock market. Just as there can be irrational exuberance in a bubble there can be irrational panic in the market. In both cases the irrationality creates a self-fulfilling prophecy. The collapse in stock prices then produced consternation among consumers when they saw the loss in value of their stock holdings.

It is clear that Barrack Obama had foreknowledge of the impending financial collapse. When John McCain asserted that the economy was basically in good shape Obama announced that McCain was not up to date. The official statistics confirmed McCain's assertion. It is not surprising that Obama knew about the impending collapse before hand. The political candidate receiving the second largest amount of campaign contributions from Fannie Mae was Barrack Obama. (The first was Christopher Dodd of Connecticut, who has long been the most important supporter of the insurance industry in the Senate.)

Fannie Mae would have eventually collapsed but some savings and loan associations operated for years in a state of bankruptcy. Usually it is the creditors that have a financial institution declared bankrupt. What a suspicious situation in which the management declares that their institution is bankrupt before it is bankrupt!

Would the management of Fannie Mae do such an immoral thing as to provoke a recession by scuttling their institution before in was bankrupt and giving up months of time to bring about some softening of the blow to financial markets? The managment of Fannie got caught cooking the books to create false accounting profits that then generated hundreds of millions of dollars of bonuses for management. For the full story see Subprime Mortgage Crisis.

The Pattern of Employment Change

At the beginning of this material a graph was displayed showing the month-to-month change in total nonfarm employment published by the Bureau of Labor Statistics. Here it is again.

The most striking thing about the graph of the monthly percentage changes in employment is the regularity of pattern. It is almost like clockwork; a movement to a particular level, then an uptick and then a downtick. The amplitude of the variations from a constant level is constant. To see how startling this regularity is compare it with the pattern for the previous two recessions.

For these employment recessions there was a period of erratic decline followed by a period essentially no change but with erratic small fluctuations and then the recovery, a period of erratic positive growth rates in employment. What a contrast!

When Will the Recession End

The recession will end only when business investors believe it is worthwhile for them to invest in additional productive capacity. There are two aspects to this. Businesses have to see the need for additional capacity to meet sales. They also have to be confident that they will not face adverse changes in governmental policies that take away profits through increased taxes or regulations and restrictions on their operations. Franklin Roosevelt tried various measures to encourage investment but he also created uncertainties about the future business conditions and climate. Consequently the Recession of 1929 became the Great Depression of the 1930's. What one hand of government gave as encouragement of investment another hand of government took away.

The Chairman of the Federal Reserve Board, Ben Bernanke, on May 5, 2009 said he sees the economy improving by the end of 2009. This is absolutely not a shred of theory or empirical evidence for this view. This is just baseless wishful thinking. As presented above the crucial element of investment in plant and equipment is in free-fall toward zero. Business is selling off inventory which is not being replaced at a rate of significantly upwards of $100 billion a year. It took the collapse of financial markets in September of 2008 to destroy business confidence; it is going take more than unfounded forecasts by the likes of Bernanke to ressurect business confidence. The Fed may take steps to make sure that lenders have plenty of funds for business borrowers but that effort is of no conseqence if the borrowers are just not there.

(To be continued.)

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