The risk of redefining recession

NEW YORK (CNNMoney.com) -- Recession? Or just a slowdown? Some will tell you it doesn't much matter - that it's a distinction without a difference. Nothing could be further from the truth - or as dangerous a delusion.

Ignorance about recessions has taken hold because of a simplistic idea that a recession is two successive quarterly declines in gross domestic product (GDP), a measure of the nation's output.

The idea originated in a 1974 New York Times article by Julius Shiskin, who provided a laundry list of recession-spotting rules of thumb, including two down quarters of GDP. Over the years the rest of his rules somehow dropped away, leaving behind only "two down quarters of GDP."

Like most rules of thumb, it's far from perfect. It failed in the 2001 recession, for example. At the time and until July 2002, data showed just one down quarter of GDP, leading policy makers to claim there had been no recession. Yet, later that month, revisions showed GDP down for three straight quarters. Complicating matters further, with the benefit of time, we now know that GDP actually zigzagged between negative and positive readings, never showing two negative quarters in a row.

The far more important issue in 2001 was the loss of 2.7 million jobs - more than in any postwar recession. Even taking into account labor force growth, those job losses were greater than in most recessions over the past 50 years.

Clearly, there are times when the reality of the economy outside your window is harsher than GDP might imply.

In fact, if you insist on using a rule of thumb, you're better off "defining" recession as a period when the economy sees four straight months of job losses, since that rule has been much more accurate. However, like the GDP-based definition, even that is too narrow a rule.

Any trustworthy definition of recession needs to encompass the key elements of the recessionary vicious cycle - output, employment, income and sales.

While all government data are subject to revision, simultaneous reliance on all four of these aspects of the economy produces judgments that can stand the test of time.

To appreciate why, we must first understand what a recession really is.

A recession is a self-reinforcing downturn in economic activity, when a drop in spending leads to cutbacks in production and thus jobs, triggering a loss of income that spreads across the country and from industry to industry, hurting sales and in turn feeding back into a further drop in production - in effect a vicious cycle.

That's why the proper definition of recession cannot be limited to GDP and industrial production, but must also include jobs, income and spending, all spiraling down in concert.

To keep it simple, just look for the "Three P's" - a pronounced, pervasive and persistent downturn in the broad measures of those factors.

Having established the facts about recession, we'd like to offer our opinion about where we are in this business cycle.

While GDP has yet to decline, we have already seen four straight months of payroll job losses. That suggests that the economy is on a recession track. And it implies that either one or both of the recent, slightly positive GDP estimates will be revised down to negative readings by next year. Or, we will see a negative GDP quarter or two later this year.

But while the final determination of recession might be delayed by a year of more, our leading indexes have never been this weak outside a recession. If this is indeed a recession, policy makers would be remiss in assuming that this is an economic slowdown rather than a recessionary vicious cycle.

Japan is a case in point. Not many know that it didn't experience sustained deflation until nine years after its asset bubble burst in 1989. That was because, following the 1992-1994 recession, the country re-entered recession in 1997, but Japanese officials were focusing on the "two down quarters of GDP" recession definition. As a result, they only belatedly recognized the reality of the recession 15 months after it had begun, when that "rule" was finally satisfied.

This enabled wrong-footed economic policy, resulting in a prolonged, severe recession that set off years of deflation. It's easy to see how definitional delusions can cause a lot of damage.

Simply put, if an economy is in recession, economic stimulus - such as quick Fed rate cuts and tax rebates - can be provided without much concern about inflation, since recession always kills inflation. Here's why: because people have less money to spend, businesses cannot easily raise prices, especially if consumers are forced to spend even more on food and energy.

But if this were just a slowdown, the same type of stimulus could set off an inflationary spiral.

That's why it is essential not to be misled by a flawed rule of thumb, or imagine that it makes no difference to policy whether or not we are in a real recession. This is even truer in an election year, when politically expedient policy prescriptions are all the rage.

Lakshman Achuthan and Anirvan Banerji are the co-founders of the Economic Cycle Research Institute (ECRI) with Geoffrey H. Moore, and the co-authors of Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy, published by Currency Doubleday.