Looking Ahead: A Bad Recession or Something Worse?

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As the economy continues to falter, Circuit City, the nation's second largest consumer-electronics retailer, filed for Chapter 11 bankruptcy protection and plans to close 155 of its stores and cut 17% of its workforce

Just how far and how fast will the economy drop this quarter? There's lately been a race to the bottom among forecasters, with the economists at Goldman Sachs leading the way. Early in the week, they put out a report saying that -3.5% annualized GDP growth was their baseline forecast for the quarter, but they also went so far as to outline a "just awful" scenario of -6.0% and a "worst case" of -7.8%. Today they updated their baseline forecast to -5%.

That puts Goldman well ahead, for the moment at least, of even Nouriel Roubini, the New York University professor known as Dr. Doom — whose current forecast is about -4%. Lots of Wall Street economists less renowned for their gloominess have by now moved past the -3% mark. In fact, one explanation for the stock market's horrible week could be that the realization of just how bad the quarter will be is finally sinking in among investors. (See the Top 10 Dow Jones drops.)

We haven't been through anything this bad in a while. The last time the economy shrank faster than 3% was in the first quarter of 1982, when GDP dropped at a 6.4% annual rate. It hasn't exceeded Goldman's worst-case forecast of -7.8% since the first quarter of 1958, when it was -10.4%.

While -10.4% sounds awful, nobody ever talks about the Great Depression of 1958. That's because the economy came roaring back later that year. This was in part a characteristic of the manufacturing-dominated economy of those days. GDP and employment would shrink precipitously one quarter as factories temporarily shut down to work off an inventory glut, then jump almost as much when they reopened. Things don't really work that way anymore — the jobs disappearing now aren't temporary layoffs, and the increased reliance on debt in the U.S. economy may bring self-reinforcing downward pressures that weren't an issue back in the relatively frugal 1950s. (When you've got lots of debt, like General Motors or your neighbor with an adjustable-rate mortgage, you're in a far worse position to weather a sudden reduction in income.)

As a result, hardly anyone is expecting a big snapback in the first quarter of next year. Then again, nobody really knows what to expect. There's far less consensus among economists about the first quarter than about the one we're in now. Some (Merrill Lynch's David Rosenberg is an example) think it will be even worse than the current quarter. Others (the majority) think it will be better. But none of that means very much, given that economists are close to hopeless at predicting that far into the future in times as tumultuous as these. It's the performance of the economy next year that will determine whether this is a deep-but-manageable recession — worse than those of 2001 and 1990-91, but along the lines of those of 1981-82 and 1973-74 — or something altogether more historic and horrific. And nobody can say with any real confidence which it will be.

For decades, economic statistician Geoffrey H. Moore tried to improve on the poor record of forecasters by identifying financial and economic indicators that had at least some measure of predictive power. The Index of Leading Economic Indicators now compiled by the Conference Board, which includes things like money supply, stock prices, unemployment claims and average weekly hours worked in manufacturing, was his brainchild. Its latest release, which came out on Thursday, showed a decline along the lines of the last recession, in 2001.

The late Moore also founded the Economic Cycle Research Institute (ECRI), a New York City firm that compiles a weekly leading index from a secret sauce of indicators. Its latest was released Friday and showed the sharpest decline in the history of the data series, which goes back to 1949. "We have plenty of gloom," says ECRI managing director Lakshman Achuthan. "But having said that, we haven't gone into doom yet."

"We do know what leading indicators look like going into a depression," says Achuthan — ECRI has a monthly index that goes back to 1919, a period covering not just the Great Depression of the 1930s but also a severe if shorter downturn in 1920 and 1921. "The magnitude of decline this index shows at the onset of a depression is materially worse than those today."

It is a measure of the temper of our economic times that this kind of talk now passes for reassuring.

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