Are recessions actually cleansing events

E when the Iran War started, the predictions were dire The head of the International Energy Agency warned of the biggest energy crisis in history given the strait of Hormuz was delivering such a huge share of the world's oil and gas supplies closure represented a nasty shock to the global economy and raised the risk of recession The recession hasn't come The global economy seems to have been remarkably resilient There's some pressure on inflation, but not the sort of spiral into a downturn that everyone was worrying about Why And if turning off the oil taps doesn't cause a recession It does This is the Economic Stro with Sama Kainnes. I'm joined here in the studio by Tyler Goodspeed Pyler is the chief economist of Exon Mobil and the author of a book recession, the real reasons economies shrink and what to do about it. Tila hell Good to be with you. I am so pleased that you are here because we have been trying to set up this conversation for quite some time. I think the first time was a few months ago when you were quite busy because you know your book could just come out about recessions, but also your day job meant that you were tied up It was a frantic March and April in particular I should specify up frront that the book and my comments here today are my own views and shouldn't be interpreted as representing the views of any other individual or entity. So on this show, we always start with a city question. on a scale of one to ten. How worried were you about a recession when there this big oil shock? First hit I'll be honest, I was probably an eight And how do you feel now I've done some more reflection on analogs to pass energy related recessions because at the start of this conflict, my mind was going back to nineteen seventy three, which was a recession in which there was a physical shortage of barrels, a physical shortage of cubic feet. And that seemed reminiscent to me in light of recent events But as the past few months have gone on, I've started to think more about some of the differences between twenty twenty six and nineteen seventy three that I think can explain some of why we haven't observe some of those dire predictions come to pass So one is simply that dollar of economic output today is less energy intensive generally and less oil intensive specifically Also today, we have a more diversified energy supply. And even within oil, Core OPEx market share is smaller than it was in nineteen seventy three, non core OPEC supply is a lot more responsive, particularly in the United States with shale and Also, we've learned some of the lessons of the nineteen seventies. and so a lot of major economies like the United States maintained large strategic petroleum reserves, even commercial inventories were well supplied, heading into the shock. So I think on lots of margins H twenty twenty six US. and UK economies were just much more resilient for a multi month long conflict and supply disruption than they were in say nineteen seventy three. Yeah, so the buffer stocks, the stockpiling seems to be a really important part of this question. I've been watching this kind of debate play out about the role of China in all of this, right? withith some people saying, o, they've been the savior, right? They're the ones who stopped importing. There's, I think a question mark over whether they've actually used any of their official stockpiles of oil. Some people saying, o actually it was that they stopped building up their stockpiles. and actually that was the thing that relieved pressure on demand How important do you think that they've been So Chinese demand has been a margin of adjustment. It's too early to determine how much of that was an official response versus how much was that just Demand in China was weaker in the first half of twenty twenty six then maybe some of the headline or official statistics would imply because some of the non official statistics suggest that underlying economic growth in China has been weaker in the first half of twenty twenty six, independent of what's been going on in the Middle East. Okay, so so stoppiling played a big role. Can I just go back to the first factor that you mentioned though? Um, If you look at the overall statistics, yes, Western economies are less dependent on oil than they were back in the nineteen seventies The counter to that is that well We did diversify away from oil. after the big shock in the nineteen seventies. And so the things that we're still using oil for are the very things that are hard to substitute away from. Right? That we can't make an electric plane And so actually in some sense, we might be more vulnerable to disruption. How important do you think that is? You hit on a really important point and it's something that really struck me studying historic recessions is that we tend to think about big macro shocks that Aect. all sectors of the economy roughly contemporaneously, whereas a lot of recessions are driven by a shock that maybe only directly impacts one sector or even one commodity But over any near term time horizon, it's really hard for households and businesses to find substitutes. So yes, output today is each dollar of output, as I said, is less oil intensive than it was in nineteen seventy three, but to a certain extent It's a bit of a truism, but in economics, we are constrained not by that in which we are most efficient or at least limited, but rather by that in which we're at least efficient or most limited So when you look at some of the hard to decarbonize sectors like maritime, like air travel a lot of industrial processes that require a lot of heat. Some of those It's just over any near term time horizon, it can be difficult to find substitutes Thinking about history again, There's a question about how long these jocks take to have their full effect. right? I mean, in a sense you might worry that actually we're not at the end of this energy shock, right? Because these things take quite a long time to pass through supply chains Are you confident that we're now out of the woods? Could this thing hit harder as time goes on One thing that I learned in the book is that there is a great deal of ruin in a nation to borrow a phrase from Adam Smith. and so it tends to take a lot of shocks or a single large shock of the magnitude of, say, the twenty twenty pandemic push a large diversified economy like that of the United States, like that of the United Kingdom into a period of outright contraction that lasts for more than a few months that spread across sectors. and that involves outright employment losses And so conditional on what we've seen this year is the risk of recession higher than in any given year Probably But as I said, it does typically take a lot of shocks or a single big shock M Can I just pick up on something you said because know we have a definition of a technical recession, right? So two consecutive quarters of a GDP contraction But you seem to think that there's a broader definition. What's your preferred definition Right. And the two quarter technical definition isn't of much use when you're trying to write a four century history of recessions because you go back farther in time and you just don't have data available at quarterly frequency I tend to adhere and I adhere in the book to the definition used by the National Bureau of Economic Research, which is the offfficial unofficial. It's a private organization, but it's the official arbiter of U. S. recession dates And they define it pretty much as I just did, that it's a period of contraction. that last for more than a few months. It's spread across sectors of the economy and typically is characterized by employment losses And actually on that point I think someone armed only plot of the unemployment rate. could do a pretty good job identifying historical recessions because one of the defining features of recessions is the substitution of a sudden sharp upward movement in the unemployment rate for a more gradual downward or sideways movement in the unemployment rate. So I refer to the late US Supreme Court Justice Potter Stewart, who when asked to define pornography, he said, Well, I may never be able to come up with an adequate definition, but I know it when I see it. And I think something similar could be said of recessions All right, so You essentially argue that Recessions are complicated, right? And as you were saying, often caused by multiple shocks And so effectively you're debunking the kind of monocoausal explanation of recessions, which is bad news for anyone saying, o, this one neat trick will help you predict a recession. Can you just go through some of the factors that Don't predict re scessions Sure, and I can summarize it up front that recessions are fundamentally unforecastable. And all of the typical tools and indicators that we often hear in the financial press the yield curve, leading economic indicators, there's a SOM indicator. You can get really sophisticated dynamic factor models with Markov switching. and all of them when you look over the past few centuries, all of them abound in false positives and false negatives Okay, but the SAM rule, which for those who don't know, measures how quickly the unemployment rate is changing. That doesn't predict a recession, right? It just tells you that you're in a recession. That is correct. Yes. So it is an indicator rather than a prediction. And I should just say on the predictability front Even though I've just written a book demonstrating that recessions are unforeorecastable I still check the SOM indicator. I still check the yield curve and yield curve based prediction models because I think of it kind of like I don't believe in astrology, but I still take a peek at my horoscope every now and then because I just want to want to see. Okay that's weird though. You look at horoscopees Every now and then I'll take a peek. Okay So in summary analysts out there trying to predict recessions, your job is mostly useless and about the same informational value as a newspaper horoscope So maybe they should give up I wouldn't say give up because one of the things that I do in the book is I highlight some of the kinds of shocks that historically have contributed to recessions. So back over the past century in the United States, there's been about a one in ten chance in any given year of an energy related recession. the past century, there's been about a one in a hundred chance of a pandemic related recession than about I think a five in one hundred chance of controls related recession. So you add up those unconditional probabilities and then you can ask yourself, okay, do I think that probability in this year additional on what I've already seen is higher or lower to me seems like a more productive approach than trying to develop models that are going to predict what are fundamentally unforecastable Okay, so ditch the models instead acquire a deep grasp of history and context. Yes Easy I suppose, you know, one thing I worry about is that Partly this unforeorecastability is the result of using too few data points, right? So in lots of the exercises, you're only looking at the US, maybe the UK There are many other countries out there. the data might not be quite as high quality, but can we not learn anything from including All of those other data points too. It's a really good point. And actually one of the reasons that in the book I studied both the United Kingdom and the United States becausecause a lot of scholars just rely on the twelve US recessions since nineteen forty five, and they think they have all these Statistical degrees of freedom because they have quarterly data or monthly data. The reality is they have twelve And so Extending the analysis to the United Kingdom adds an additional five post nineteen forty five recessions. And there's an interesting difference there I mean just why was the United Kingdom historically less recession prone than the United States, but we could get into that later. But then also extending it back in time to all the way to seventeen hundred. So we have I have one hundred and thirty two recessions that I deal with in the book. Okay, well, why don't you dive into that? So there is this difference between the US and the UK in terms of their recessions. The UK seems much less recession prone, an area where we beat the Yanks. Forust Why is that Sure, And first of all, just to put numbers on it Over the past century, you had nineteen thirty seven, nineteen fifty three, nineteen fifty seven, nineteen sixty, nineteen seventy, nineteen eighty one, and two thousand one that were US recessions each We're not UK recessions And if you go back two hundred years The U.S was approximately twice as recession prone as the United Kingdom. And though we might think that that's because perhaps Brits are less prone to mania and panic than Americans. They're more stayed But the reality is more prosaic Firstly, it's because from eighteen twenty six on, the United Kingdom had a broadly diversified national banking system And so you can bank across the country. And if you think about a large diversified national economy,' kind of like a large diversified portfolio, then weakness in one sector or region can be offset by strength and resilience in another sector. in contrasting the United States up until the nineteen eighties Not only could banks not operate across state lines, they couldn't even operate more than one branch within a state. And so we had literally tens of thousands of tiny, under capitalized, underdiversified financial institutions the failure of which in response to local shocks could really amplify and propagate those shocks The second prosaic reason is that most of the post war US recessions between nineteen forty five and nineteen seventy three were oil related. During that time, the UK economy was just much more coal intensive And so they were more insulated from those shocks. And the UK went from nineteen twenty six to nineteen seventy two without a single official coal strike Okay, so our brilliant banking system and also coal saved us, maybe not what people are expecting. Can I go back to these other countries though? So know you've now been talking about your book for a few months and presumably speaking to people around the world. Have you heard from other people that, oh, you know our country is different or our country is similar? So why I get asked pretty frequently about is China And it's usually in the context of why doesn't China experience recessions which struck me as kind of an odd question because China had a recession recently possibly even had what we sometometimes call a double dipper re scession during the twenty twenty pandemic and twenty twenty one in China China also possibly had a recession in nineteen eighty nine. Perhaps that was correlated with some of the social unrest we saw in nineteen eighty nine in China. You can go back to the nineteen sixties and during the Great Leap forward, China experienced a devastating recession. They've experienced another devastating recession toward the end of the cultural Revolution So I think this is a reminder that no economy is immune from recession There's never been an infinitely lived economic expansion Okay, so it is what you're saying that actually China isn't so different to the West in terms of its recession dynamics. I'd say that it's a reminder that recessions are fundamentally about adverse shocks rather than about processes that in hereere in growth itself and market economies. And actually on that front, it's really interesting because go back to the interwar period in the West There were scores of very eminent economists who were trying to develop models and theories of the self generating business cycle At the same time In Moscow, there was a Soviet economist Ogan Slutsky took old immperial Russian lottery ticket numbers and constructed a moving sum from those digits And the resulting series mapped almost perfectly onto an index of business conditions in the United Kingdom for almost half a century. And what it demonstrated was that the summation of chance or random causes can generate what looks like cyclical behavior even though the underlying data generating process is in fact random I wantna go back to energy shocks, right? Because your argument is that recessions are often caused by multiple shocks, but there are some patterns. And one of them is that energy is a repeated villain And the recession I was most interested to hear, this revisionist history, was the global financial crisis, where you argue that actually energy did play an important role What happened there asked when The inflation adjusted price of a barrel of oil reached its all time high. One might ould justification guess nineteen seventy three during the Arab oil embargo, or maybe nineteen seventy nine in the aftermath of the Iranian Revolution or nineteen ninety during the Iraqi invasion of Kuwait, answer is actually june two thousand eight In fact, the The Price of energy overall has never been higher than it was in june two thousand eight due to a confluence of shocks to both energy supply and energy demand. the result of which was that by summer two thousand eight, the average American household was having to spend a record amount on energy goods and services and two thousand dollars more than they've been having to pay just a few years prior. At the same time that their mortgage interest payments are resetting higher in part because inflation's gone up. so interest rates are going up That two thousand dollars figure that's per year twenty six dollars adjusted per year per year. Yes. And remember A tax About half of American households have no savings And these are not expenditures on which it's easy to economize.'s you commuting to work, dropping your kids off at school, heating and cooling your home, putting food on the table because when the cost of energy goes up, the cost of fertilizer goes up. So food inflation in the United States that summer top six percent Faced with those constraints About five percent of American homeowners are seriously delinquent on their mortgage And the rest as they say, is history It's like the scooboooo villain and you lift the the white sack and actually it's synergy U And what is it about energy that makes it so potent when it comes to causing recessions There are multiple channels. One is that it's a direct input into so many products, so many services. And it's just difficult to find substitutes over any, say twelve month time horizon, which is about the duration of the typical recession It's also a complement to capital and production because capital becomes more efficient with access to energy And then also for consumers It's non discretionary. I mean, you kind of have to spend on a lot of these things like commuting to work, like heating, cooling your home And so you cut back on a lot of other purchases when the cost of energy goes up. You may also defer purchases of energy intensive goods like appliances, like automobiles And you also might be kind of nervous because if you know that there's this energy shock then there's a higher probability of future income or even employment loss. And so that results in precautionary savings. So there are all these different channels through which energy supply shocks can contribute to recessions. Okay, sounds scary. Shouldn't the world just Do the green transition, you know wean ourselves off fossil fuels and then we'll be much, much less vulnerable to these kinds of shocks coming from geopolitical factors, that sort of thing. Would that make us more resilient to recessions Fundamentally is diversification helps with resilience And that's diversification across energy types that's even within energy types, that's diversification of supply where you're getting it from because you don't want to substitute one vulnerability for another But generally speaking, diversification is key for resilience. and we see that with banking One thing you hear often is that it's not the energy shock. can cause a recession, but it's the response to an energy shock Right? And so the energy shock might say raise inflation, central bankers might get worried, might raise rates and that is actually the thing that slows down the economy How important do you think that dynamic is? It's a factor. So that's a channel through which Ben Bernanki identified energy shocks as having an impact on the economy And the tricky thing there is the conventional wisdom is so long as inflation expectations remain anchored Central bankers have historically been advised to look through temporary supply shocks If inflation expectations do rise, then that creates more of a trade offer for central bankers to consider I should note, there are other sectorial shocks that one observes studying four centuries of economic recessions. So a relatively mild recession in the US in nineteen sixty was very much steel related to a recent industrial election in the steel industry. If you go back farther in time, cotton was a failure of the cotton harvest in the United States was a frequent contributor. So these are all types of products similar to energy in the sense that they are used in a lot of different sectors. So the linkages from that one sector to the rest of the economy are very high And over any near term time, horizon it iss very difficult for households and businesses to find substitutes. So cotton was the cause of the eighteen sixty two UK recession Okay, But if you take that model then you know, you've got particular commodities, cotton or energy, the problem seems to be that the economy isn't diversified enough, right? So when a shock comes along, it's a disaster By the most recent experience with the Big energy shop didn't and hasn't so far ended in recession Could it be that we've diversified enough now? Could it be that that recession generating process has changed over time as the economy has changed is cause for optimism, I think that Gotten. better over time at absorbing some of the kinds of shocks that historically would have been near guaranteed to generate a recession And so what I find in the book is that economic expansions on both sides of the Atlantic have been living longer And that is a process that goes back all the way to seventeen hundred. So there are no clear structural breaks specific points in time toward longer lived expansions. that is a long run structural trend as we've 've diversified our economies. We've learned how to better absorb some of these shocks comoming up toward july fourth possible exception is seventeen eighty five in the United States. There may have been a break toward longer lived expansions. and you can think about some recent institutional changes near that date So is what you' saying it was the Brit' fault Uh I love that. It was just was a warfare for. It was a warfare. Okay, fine, right right Okay, so so maybe before that breakpoint, there was a lot of war and that was bad for the economy. And since then, we've had less war. And let's all hope that continues. And war that really visited American soil in a big way. because these were wars on their soil, for example, the Seven yearsars War, and then you had the American Revolution, which was really Pression magnitude events Let us go to a break now, but when we get back, I want to ask you about whether an AI bubble could cause a recession and whether recessions could ever have positive effects Investing with Schwab is like spending a Saturday at a great farmer's market. You can fill your reusable tote with a bit of everything. Maybe you go for some free range self directed investing, or perhaps you pick up a few farm fresh trades while you peruse. You can even get help from a dedicated advisor. That's full service wealth management. Mix, match, and change your mind whenever you want Because at Schwab, you can invest your way. No matter your goals or appetite for investing, Schwab has everything you need, all in one place. Visit Swab. com to learn more Wheel back from the bak So Tyler, there has been some talk, rather a lot of talk in fact, about a potential AI bubble. and then also the concern that if that bubble bursts, it could cause a recession What do you make of that idea? It's a concern I've come across in the past, but one thing I find in the book is that what we call bubbles, whether it was canals or railroads or fiber optic cables were're more likely to be the casualty of a recessionary shock elsewhere in the economy cause thereof. And one of the things that really surprised me is that there's a lot of chatter about spepeculative manias followed by panics and crashes, these unsustainable booms. When you look at the real physical infrastructure of a lot of these transformational technologies, be it canals or railroads or fiber optic cables real physical infrastructure is remarkably faithful two long run trends, and those trends resemble a pretty smooth S curve. So like if you plot Cumulative canal, mileage, cumulative railroad track, cumulative fiber optic miles. Those are very smooth S curves you have a slow ramp up and then as you learn and efficiency improves, you move faster and then as you reach the saturation, you sort of tail off. So not like a crazy spike. Correct. And you know, if you read a lot of secondary sources on economic fluctuations in the nineteenth century on either side of the Atlantic, you might conclude that railroads and speculative excesses in railroads were serial killers of economic expansions in the nineteenth century but then just plot that cumulative railroad mileage track and you don't see know big fits and stops let alone big fluctuations, you see a very smooth Hers that exhibits remarkable fidelity to trends. Does that necessarily mean that the speculative behavior had nothing to do with overall economic output though. I mean, just thinking about AI, it could be transformative technology, arguably it's already transforming much of economic activity. And so you'd expect to see that big rollout But the fear is that the valuations, if there's a crash that has ripple effects through the financial system, it's that activity that could be the spark of something bad and you might worried that that could happen kind of independent of the physical infrastructure installation But here's where I say, I think those valuations and subsequent economic consequences are more likely to be the casualty of a recessionary shock like a big interest rate spike or an energy shock cause thereof And I'm reminded here of two thousand one, which everyone calls the dot com recession Everyone calls it the d. commce session. But the decline in tech stocks in the United States was just one of at least four shocks impacting the U. S economy. And I demonstrate in the book that quantitatively it was the least important in part because it was already over. I mean, the NSDAq has started to recover by the start of that two thousand one recession And also, stock ownership is very highly concentrated skewed toward higher income, higher net worth. households who tend to be less responsive to changes in financial wealth reallyally recession, the biggest shock during that recession where the terrorist attacks nine ele And in fact, all of the output contraction during that relatively short, relatively mild recession occurred During the three months that included the terrorist attacks, the complete shutdown of U. S. airspace, widespread fear among households and businesses. Without the terrorist attacks at nine hundred eleven, I don't think there would have been a two thousand one recession. All right, so everyone worried about the AI bubble busting, maybe calm down Now I want to ask about Um the effect of recessions on the broader economy. Because as you say, these areas of speculation could be a casualty of recessions. Now in some cases, there may be a question about whether that's a good thing So there's this big debate about whether recessions are cleansing, whether they are the force that weeds out all of the weaker companies that really should have collapsed a long time earlier What do you make of that debate? It's an argument that I want to be true Recessions are painful, they're traumatic. so you want the pain to at least be worthwhile But the reality is that while so called creative destruction is important for long run growth process is impaired rather than enhanced by recessions So recessions are rampant age discriminators. They discriminate against younger workers, they discriminate against younger, more dynamic firms They really collapse. The whole ladder by which people and capital move from less efficient to more efficient enterprises because during expansions, One of the key mechanisms by which people move to more productive enterprises is they quit one job and are hired into another job and two features of a recession. pretty much every recession are that quits comment People don't feel confident leaving a job and hiring plummets. Firms don't feel comfortable hiring So a lot of the mechanisms by which expansions enhanced reallocation, reocative churn are actually impaired during recessions and research and development falls during recessions And also you can look few years out from a recession. Tyhically, the allocation of people in capital and output across the economy looks pretty similar to how it would have looked H the economy continued uninterrupted aong trend? There's just no saving grace. There is nothing good about recessions So unfortunately, recessions perform no good However, I think there is a reason for optimism and that is that we have been getting better At avoiding recession, economic expansions have been living longer What's interesting is that if you look at the United States versus United Kingdom, the United Kingdom has historically been less recession prone than the United States, as I noted. But the United Kingdom is also and has long been about thirty percent poorer per person than the United States. And I think that speaks to the fact that while we worry a lot about recessions because recessions hurt a lot of people probably ought to be at least as concerned about the majority of years in which economies expand as we are about the minority of years in which they contract. because at the end of the day the majority of years in which they expand that matter more for prorosperity and indeed human flourishing Okay, so you Brits might be feeling smug that you haven't had as many recessions as us Americans, but it's still poorer. so thinkink about that Think about raising trend growth. Ey easier said than done