Podcast: Learn to read the economic tea leaves

Are the chances of a recession increasing, and if so, should we be altering our behavior? Economists use various economic indicators to track segments of the economy, to explain current behavior and project future activity. Dennis Hoffman, professor of economics and director of the L. William Seidman Research Institute at the W. P. Carey School, talks about these bellwethers, and what they say about the current economic situation.

Are the chances of a recession increasing, and if so, should we be altering our behavior? Economists use various economic indicators to track segments of the economy, to explain current behavior and project future activity. Dennis Hoffman, professor of economics and director of the L. William Seidman Research Institute at the W. P. Carey School, talks about these bellwethers, and what they say about the current economic situation.

Transcript

Knowledge: If you want to find out what the future holds for the economy, there are tools much more reliable than tea leaves or magic eight balls. Dennis Hoffman, professor of economics at the W. P. Carey School of Business explains how various economic indices track certain segments of the economy. Taken together those indices not only form a picture of the current state of the economy, they also act as bellwethers for the future.

Dennis Hoffman: The economy in the spring of 2007 is doing well, but it also depends on one's perspective. In terms of thinking about indicators of the economy, [there are] metrics [that] we can use to measure the pace of economic activity. The answer actually is [that] it depends a bit on one's perspective. If you are in the construction business, if you are in a business that is close to the housing market, chances are economic conditions are not nearly as rosy as they were 12 to 24 months prior.

If you are in the Midwest of the United States or working in any area close to automobile manufacturing, close to mainline manufacturing activities, the kind of old industry manufacturing activities in the United States, you are struggling a bit. In contrast, if you are in financial services, if you are in many of the business services areas in the United States, you are doing reasonably well.

And as a matter of fact, until very recently, if you were close to any of the activity in the financial market, you were doing very, very well. So we have a bit of a contrast in terms of economic activity across the United States right now. And the key to this issue is to establishing indicators or metrics that we need to use to monitor the pace of the economy and to concentrate on getting a read, an early indication of how economic conditions might change.

Knowledge: So we are monitoring this within indicators, what in this particular should we be looking at?

Dennis: Indicators that portend future economic activity tend to be, first of all, activity on Wall Street and the activity in the financial markets tend to portend future economic activity. A benchmark indicator that is produced right here in Tempe, Arizona by the Institute of Supply Management in conjunction with the W. P. Carey School of Business is an index of supplier activity.

The ISM or the Institute for Supply Management index that comes out monthly is very highly correlated with the current pace of economic activity and they do a read based upon both production activities and service activities in the U.S. And the production activity indicator has been moderately weak but not signaling a recession. The services indicator has just turned surprisingly weak but is still not quite signaling recession. So those monitors are important.

Those metrics are important. Other metrics that are important are orders for equipment — orders for durable equipment — and those orders have shown some weakness recently. Some data that has just come out has suggested that durable equipment orders have really plummeted, and the economists are debating as to whether that is a one time factor associated with the airline industry. Other economists are concerned that indicators associated with the overall housing market have turned weak.

All and all, if you sum up all of the indicators today, the risk of recession is probably moderately higher today, in the spring of 2007, than it has been for several months. The things we need to continue to look at? First of all, the jobs report will be very, very interesting to monitor going forward, but the pace of world equity markets probably matters more today in 2007 than it has ever mattered before. So that is a very, very important indicator of economic activity.

Knowledge: Well you said that our chances of a recession are moderately higher, but Alan Greenspan has said that the chance of a recession is one and three. Does that square with what you have been seeing? Are we headed to a recession?

Hoffman: The Association of Business Economists, this spring, put the chances of a recession this year 2007 at approximately one chance in four. Mr. Greenspan, the former Federal Reserve Chairman, has been on the lecture circuit recently. He raised the specter of recession in late February that led almost immediately to a fairly significant sell off in equity markets around the world. And following that, in early March, Mr. Greenspan has raised his personal forecast of recession to one chance in three.

That suggests, I think to many economists, that the chance of recession is greater today than it was perhaps over the last six months. The fascinating thing from the perspective of economics is that when you have important, high profile people raising the probability of recession, and having that publicized around the world, the prophecy can, to some degree, be self-fulfilling. And here is how that works.

If consumers and businesses in their own minds raised the probability of recession and react by not buying goods and services or not investing in business equipment, then their very act of hesitation actually increases the probability of recession as well. So to some degree, more "talk" about the higher probability of recession can be a self-fulfilling. It is an interesting psychological phenomenon in economics, but certainly consumer and business behavior is an important piece of the puzzle.

Knowledge: What about stock market? We have seen over the last few days just the turmoil in Asia and how it just spread throughout the European and the American markets. Is that also an indicator or are we seeing a correction that has been anticipated for a while? And are investors looking at the fact that there are less experienced people in China who are in the stock market and they may be reacting a lot more sensitively than some of the more experienced people would.

Hoffman: Equity markets around the world have taken on increased importance in the 21st century. In the last several years — 2005, 2006 and now into 2007 — activity in the so-called "emerging market areas" has been very robust. Much of the world news has been focused on China and the Shanghai market, but if one were to peruse the indices in emerging markets — in Latin America, in Asia, and some parts of the middle east — you will find that there has been significant run-ups in equity prices around the world especially in what historically has been labeled "speculative emerging markets."

It is interesting from an economic perspective that investors have been willing or seemingly willing to take on risk that has historically been associated with these emerging markets. Further, it is going to be interesting to see how this plays out. What we have observed most recently in late February of 2007 and early March, is that there has been indeed a correction that apparently started in the Shanghai market following a massive run-off over the last year in Shanghai where equity prices went up approximately double over the last year and there were rumors of speculative bubbles in China. So natural corrections from a speculative situation like that are quite expected.

But corrections then took place around the world and it might be the case that we will find that, following these very significant corrections, that investors around the world will decide that they are not willing to take on quite as much risk as they have in the last several years. That might result in increases of investments in first world countries like Europe, the United States, and Japan, and we might see that these historically more reliable markets actually get more attention as investors pull back from emerging markets and invest more of their funds in first world economies.

Knowledge: How should individuals plan for tough economic times and how can they look at these indicators and makes some sense of them. That this is something that is going to be happening or not happening.

Hoffman: Individuals can plan for recession or they can plan for possibility of difficult economic times by having, first of all, diversified portfolios in terms of their retirement portfolios or in their investment portfolios. They can be situated so that their income-to-debt ratios provide them some comfort, provide them with some savings to draw down upon in the event of job separation, in the event they are stretched beyond their means for several months.

The concern that economists would have about say a prolonged or deep recession would be that it hits individuals that over the last few years have overextended themselves in mortgage situations where they have reached to buy homes and that have subsequently lost equity using financial instruments that are increasingly more costly through time.

And then if they are challenged in the labor market by a recession and have a job separation, or laid off for a time, or have to change jobs, that can cause a lot of financial stress in households around the nation, and especially in those areas that have experienced the massive run-ups in real estate price appreciation over last few years. Having said all of this, we have to keep in mind that economists are arguing about whether or not the chance of recession is one-in-four or one-in-three.

The odds are still that in the year 2007, we will not see a recession in the world economy or in the United States. It is simply that the risk of recession is now slightly higher than agents have thought it was in the last few months. The prudent strategy, the long, long-run strategy would be to maintain current consumption patterns, maintain current savings patterns, not be overextended but not hold back from making planned purchases either.

A sure fire way for us to bring on a recession is that if everybody pulls back from their planned purchases and chooses not to consume but to save for the proverbial rainy day. That would make a recession a sure thing. So it is an interesting phenomenon that prevails in the US and in the world economy. And if people become too timid and too conservative in planning for a rainy day. or planning for an impending recession, they can actually bring it on.

That is something that we have always dealt with. In the popular phrase, it goes all the way back to Franklin Delano Roosevelt when he told the American people that the only thing they had to do fear was fear itself. Of course those were drastically different times than we confront today, drastically different. But the psychology and the impact of the psychology remains the same.