USA finance

In an unusual economy, these financial dangers may be of more concern than a recession

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Spiking inflation was the story of 2022, while recession risk could emerge as the dominant economic theme for 2023.

But is it really that big of a deal? Maybe not, at least in today’s environment.

Granted, recessions usually are painful, especially a big one like that from 2007 to 2009. Unemployment rises, companies fail, businesses and people file bankruptcies, the stock market tanks and home prices often soften.

Some of those problems have arisen lately, but not all. The job market remains unusually vibrant, with the latest U.S. unemployment rate, 3.5% in December, below where it started in 2022. A recession still hasn’t materialized, and some indicators for predicting it don’t seem to be working.

Perhaps a recession isn’t the biggest economic danger on which we should focus.

Stagnant long-term outlook

Though recessions are painful, they usually are fairly brief. Only three of the nine recessions dating to 1960 have lasted more than a year. Instead, long-term stagnant growth is a bigger risk, argues John Cochrane, an economist at Stanford University’s Hoover Institution and a professor of finance and economics at Stanford’s Graduate School of Business.

Rather than focus on quarterly changes in the U.S. economic growth rate, which is how recessions now are gauged, the long-run expansion of the economy, or lack thereof, matters more, he said in an interview excerpt published by the university. In particular, stagflation – slow or no growth with elevated inflation – can be debilitating, as happened in the 1970s.

Unemployment typically rises during recessions, but Cochrane argued that labor force participation matters more. Participation measures the percentage of working-age adults in the labor force, either employed or looking for jobs. By contrast, the unemployment rate focuses on the number of people who are out of work but looking.

Labor force participation doesn’t gyrate as much as the unemployment rate, but it has gradually declined from about 67% in 2001 to near 62% today, partly reflecting millions of baby boomers retiring.

People also misunderstand the nature of unemployment, Cochrane said. Even in recessions, most workers find jobs sooner or later, but a long-term decline in labor force participation points to lower overall economic output and personal incomes.

How to tell if a recession hits in 2023: Keep a close eye on unemployment, consumer spending

A false recession signal?

One of the most widely followed recession indicators relates to the yield curve, or the relationship between interest rates paid on different maturities of debt.

Normally, bonds with longer maturities pay higher yields than those coming due sooner. On the latter, investors get their money back sooner, face less risk and usually are willing to accept lower returns. But when yields invert – that is, when bonds with shorter maturities pay more – it could signal that a recession is on the way.

At least, that’s the conventional view. Yet the yield curve inverted around mid-2022 but a recession hasn’t yet materialized. In fact, U.S. economic growth perked up later in the year. The outlook for 2023 remains inconclusive.

“We think the odds are roughly a coin toss that the U.S. economy falls into a recession in 2023,” wrote Lawrence Gillum, a fixed-income strategist at LPL Research.

Gillum cited two possible reasons why the indicator isn’t working so far. One involves the Federal Reserve hiking short-term rates at an unusually face pace. The second acknowledges that all of these yield changes began when interest rates were at abnormally low levels. And there might be other explanations, such as recessions not happening all that often, suggesting that signals that work a few times won’t always do so.

Gillum noted that consumers are still spending and businesses continue to hire new workers at a healthy pace.

“Economic models help simplify a complex world but it’s important to remember that (a) signal isn’t always accurate and sometimes things are, in fact, different,” he said.

A $5 Venmo request?: How inflation is changing the way people use payment apps.

Possible role of accounting fraud

Can misleading financial statements issued by corporations help predict recessions? Yes, say researchers at the University of Missouri and Indiana University. They found that many businesses submitting misleading statements can serve as an early warning sign of a looming recession.

“When financial reporting is not adequately monitored and companies manipulate financial information, it can have potentially damaging consequences,” Matthew Glendening, a professor of accounting at Missouri, said in a prepared statement.

Exaggerated sales numbers are one type of misstatement, the researchers noted. Problems also can arise with profit margins, accounts receivable, overhead expenses and other areas.

Investors base decisions on the information presented in corporate financial reports, and so do various businesses. “In many cases, firms make employment and investment decisions based on this information, which can be way too optimistic,” he said.

One problem with using this type of analysis is that accounting irregularities often don’t surface for years, if at all, the researchers noted. And even when they are disclosed, the economy might not fully feel accounting misstatements for another five to eight quarters, they added.

Still, indications of financial-report problems could provide clues. If you start to notice a lot of news coverage of accounting scandals, it could signal that the economy might weaken down the road.

Recessionary effects on federal debt

Federal spending usually rises sharply during recessions, as the government tries to jump-start the economy while offering aid to those who are suffering, including through tax cuts. Often those measures prove effective, yet the debt continues to pile up.

A new analysis by the Committee for a Responsible Federal Budget assesses the debt overhang and paints a stark picture of a perilous situation.

Politicians, and Americans generally, aren’t yet willing to make the hard choices to pare down the debt or even rein in annual budget deficits that add to the debt, the nonpartisan group said. Of special concern, deficit-reduction proposals often exclude military spending and programs like Social Security and Medicare, all but necessitating huge cuts everywhere else.

The committee’s analysis assumes leaders could balance the budget in about 10 years if federal spending was cut by 26% across the board. But if Social Security, Medicare, defense and veterans programs were off limits, they would have to slash the rest of the federal budget by 85%.

The path to a balanced budget within a decade or so is “virtually impossible if major parts of the budget and tax code are exempt from change,” the group wrote in its analysis.

The organization urges policymakers to set aggressive but realistic fiscal goals, to keep all areas of the budget on the table and to get serious about debating policies that could reduce the deficits.

Reach the writer at russ.wiles@arizonarepublic.com.

Source: https://www.usatoday.com/story/money/personalfinance/2023/01/17/more-dangerous-to-us-economy-than-recession/11065026002/

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