Understanding the Depression Index

A week ago, I presented a new index - what I call the Depression Index - in an article at RealClearMarkets. This post explains the index in more detail.

I developed the measure to help get a grip on how bad the macroeconomic situation in the U.S. actually is, having made this same point among colleagues: "This recession is fundamentally worse and different than anything since the Great Depression for one reason (and maybe more). The only comparable spikes in unemployment in modern history happened when the central bank caused interest rates to rise, episodes in 1974 and 1980-82. This time, the Fed is pushing rates in the opposite extreme, with the same outcome." I decide to quantify my argument, but extended the logic to consider the other policy tool, counter-cyclical fiscal policy (deficit spending and lower taxes). It is also often used to fight recessions, but this tool has also been stretched to the extreme as well.

The Depression Index compares three broad measures of capacity: The Fed Funds rate, the annual budget deficit rate (annual deficits as a percentage of Gross Domestic Product), and the basic monthly unemployment rate. This first chart shows each series independently:

 

We can see that the FFO and URATE were quite stable and closely related around the 2-7 point range during 1990s and in the 5-10 point range in the mid to late 80s. They have diverged sharply now, as has the deficit rate. If anyone is interested, here is the spreadhseet with all the data and source links.

When you combine the three series, you get the depression index:
Depression Index = Fed Funds - Budget Deficit (Surplus) / GDP - Unemployment Rate

 

The current index is negative 23.1, twice as low bad as any time on record (Note: FFO data extend back to 1954). What does this mean? Well, it is easy to mock the index and suggest that the central bank just raise the FFO to 23.1 and all will be well. That works for me, as long as you are happy with the consequence of nuking the American economy. Not the point. What the index tells me, at least, is simply that policy capacity is overstretched. I tend to be dismissive of actual "depression" talk, but this index honestly makes me recognize that the macro economy is in an extraordinarily abnormal situation, and normal analytical tools, models, forecasts may not be worth very much. It also suggests the macro economy is fragile enough that any additional shocks will not be cushioned and instead cut into economy capacity severely.

Two objections to the index occur to me. One, fiscal policy is meant to be counter-cyclical but has a lag, as does monetary policy. Timing is a fair point, but difficult to resolve. A remedy would also obscure the present situation. A second criticism is that the deficit is less salient as a measure of policy capacity than budgetary debt. I am tempted to consider that, but again, it feels like there is some boundary to the amount of deficit financing that can be executed in a single year, making it a fair measure of immediate capacity.

In any case, we can consider a 2-component depression index that leaves aside fiscal policy. Consider this next chart:

Here again, we see an unprecedented policy-economy overstretch. The unemployment rate has rarely exceeded the fed funds rate by more than 4 points, touching beyond 6 just once in the summer of 1958. But now the gap is just over 9 points. In other words, our present situation defines what economists call being "out of ammo."

Unfortunately, the most recent labor data established two ominous milestones. First, the May numbers  mark the 17th recessionary month, which makes this the longest NBER declared recession (two prior "longest" recession were 16 months in duration). There's always the possibility that the NBER says a year from now that the economy started to recover in May or June, but I would not bet my job on it. Second, the unemployment rate net change of 4.5 points is the biggest in modern history. And both of these milestones are probably not endpoints.

Comments

[anon]

You can't be confident your index is measuring what you hope unless you know what the index would look like for the 1930s.
(If FFO is unavailable before 1954, as you say, you could proxy it by regressing it on whatever short term government interest rates have data available for that far back, and using the estimated FFO for the 30s to do the computation).

[repot depot]

Interesting, any idea what this chart looks
like for Japan over the same timeframe?
They may have some insight into the concept
of pushing on a string.

[richard]

What anon said: you can't be confident in what your measuring if you can't go back to at least 1930, and preferably earlier.

And you are mixing apples, oranges and bannanas. What is to say that unemployment shouldn't count twice as much as, say, the deficit? Why should FFO be added but the other quanities subtracted. I understand the desire to come up with a single "misery number", but there still has to be some intellectual justification for how the number are combined.

[Tim Kane]

anon, richard -

I agree that it would be nice to see the data back to 1930. Or 1830 for that matter. But I wouldn't say this is a useless metric because it lacks longevity. There's never enough of that. At least by limiting the first version of this index to available data, we can be conficent that we are comparing data of similar high quality. As for weighting each variable, I'm not sure that is useful unless you have a weighting in mind and some rationale for it. My rationale for equal weighting is just to make the point that the gap between underutilized economic capacity and overutilized policy capacity has never been greater in the last 57+ years. That alone is a strong enough statement to chill my blood. If it inspires further research and refinement, all the better.

[Michael Turner]

"Recession severity index" might be a better term, of course, just not as eye-catching.

If you'd like to refine this metric with other variables: The CPI is apparently trending down in recent months. It seems at first an odd figure to include in any formula that might be called a "misery index", since deflation makes things more affordable, all other things being equal. But all other things are not equal: Downward pressure on consumer prices actually indicates a perceived lack of affordability, which is not exactly a happy condition for consumers.

The first few years of the Great Depression featured about 10% deflation annually, with Fed policies that virtually promoted deflation. That deflation was wonderful if you were on salary, perhaps, but the private sector was shedding jobs at a similar rate -- deflation was conveniently enriching only for a rapidly shrinking base of consumers. The fact that we're seeing any disinflation at all, right now, despite huge injections to the monetary base and a rock-bottom Fed funds target rate, surely indicates some chilling similarities to the early 30s.

What we should really fear is a deflationary spiral: where expectations of decreasing prices begin to contribute to a flight from consumer spending even for consumers who can afford the same, or more. (As opposed to the more obvious factors: because the equity they depended on for retirement has been almost halved, or for fear that their jobs are next on the chopping block).

How would you measure the distance to the cliff's edge? I believe we're still quite far from general deflationary expectations, that price decreases have to be much more perceptible, for much longer, before it becomes noticeable enough for a vicious cycle. But it would still be useful to know how widespread the perception is at this point. Of course, it might be hard to predict what level of perception triggers a significant change in behavior, in much the same way that the bursting of bubbles is hard to predict -- a very similar phenomenon, come to think of it.

[John Bailey]

I was thinking along the same lines as Michael, but my concept is to call it the "Recovery probability Index."

I would also like to change the metric some. I think that you out to replace the Federal Funds rate with the Monetary base. In all probability, the FF rate won`t drop below 0% but they can keep rapidly expanding the monetary base.

I would also consider adding, consumer and business debt, percentage of homeowners "under water," and, possibly, some metric that measures bank`s `troubled asset ratios.`

The thing that sends chills down my spine are the massive failed guarantees that are coming due. This downturn has greatly accelerated the time frame by which those failures will become apparent.

[Michael Turner]

John, probabilities go from 0 to 1, and Tim's index is negative.

Also, the FF rate won't "in all probability" go negative because it can't, obviously.

Or do you mean FF rate in real terms? Then you've got a good Depression indicator, because that number *can* go negative, it seems it already has. The further into negative territory it goes, the more of you have the threat (or the reality) of a deflationary spiral.

If you're going to adjust Tim's formula, real interest rates might be the place to start. Piling on more variables that are mostly dependent on those he's already working with carries the risk of double-counting one factor or another.

If there's a variable I'd seriously reconsider, it might be the deficit. Why? Imagine that the current popular pressure to balance the budget resulted in an attempt to do exactly that. We reduce the deficit somewhat and the Depression Index looks a bit brighter. For a little while. But then we *would* be headed into a Depression. Ironically, we wouldn't even be able to balance the budget, because, with a full-blown depression, tax receipts would go into free fall.

We're going to be running deficits for a while -- when the recession ends, and during what's likely to be a long, long recovery period. In 1933-37, the U.S. economy was recovering as fast as it had fallen in 1930-33. Then FDR tried to balance the budget, and something happened that resulted in economists coining the term "recession". (Yes, the first "recession" by that name was *during* the Great Depression! And it was triggered by a return to fiscal conservatism.)

Since recent recoveries have been "jobless", Tim's Depression Index probably wouldn't move up much for a while, even during a recovery.

If the goal was "Depression Probability Index", then if I'd add any other factor, it might be "popular pressure to balance the budget", an easily-found poll number. Then things look dire indeed. But since it's a measure of how economic conditions compare to those of the Great Depression, including fiscal conservative sentiment would be wrong, because FDR's programs were actually widely popular.