Recession Detection using Effective Demand limit
I worked with Dwaine Van Vuuren of Recession Alert a few months ago on using the effective demand limit to detect recessions. He said the effective demand limit gave the best detection of a recession he had ever seen. He said he had seen hundreds. I want to show you one graph he came up with.
This graph is a measure of the gap between real GDP and the effective demand limit. I already showed how this limit will signal a recession in a prior post. This graph from Dwain goes deeper.
The graph shows the “Percent change over one year” of the gap between real GDP and the effective demand limit. The gap was made negative (flipped upside down basically) so that the plot would show a recession down below. (recessions shaded in) (graph up to 1stQ-2013)
Link to Graph
The pink line marks the threshold at 1.6%. In every single case, when the plot broke below the pink line, a recession was currently happening or imminent. The bottom red line was added because of the false positive in 1997. My view is that there was distorted data for 1997.
Apparently from Dwaine, this is a very reliable method to detect a recession. He has since used the effective demand limit to make even better methods to detect a recession, but I will leave it to him to share and publish that work.
The basic explanation of this graph is that the year-over-year gap between real GDP and the effective demand limit narrows above 0% in the graph and gets wider below 0%. An economy recovers from a recession over 0%. (note: When the plot goes back down to 0%, it is concluded that the recovery (within the effective demand constraint) is over.)
A recession is signaled after the gap has narrowed to 0% and then starts widening again. Once the y-o-y “rate” of widening surpasses the threshold, 1.6% in graph, a recession is tumbling in.
As of the 1st quarter 2013, we were not in a recession.
Related reading on business cycles
Detection is good, but would not prediction be better? If we knew ahead of time, measures could be taken to prevent a recession. Maybe detection is the first step in the progression of detection, prediction, prevention.
Jerry,
Actually look at the prior post where I put up showing the graphs of real GDP hitting the effective demand limit before a recession. I can predict a recession to start forming some time in the second half of next year if real GDP expands normally. There is a link to that post in the article above. The link says… “prior post”
That’s right. I remember that post. It brings up the interesting idea that one way to prevent the recession is to slow down the GDP growth.
Jerry, You know, you’re actually right about that. But how are you going to slow down entrepreneurs who are driven to make money? how are you going to slow down business competition?
Create a recession? Oh wait!!!