It’s an age-old conundrum: Did a chicken lay an egg, hence, more chickens? Or, did an egg hatch into a chicken, hence more eggs?
You could ask a similar question regarding the economy: Did a fall in stock prices cause the recession, or did the recession cause the demand for stocks to fall, hence negative growth?
A recession is generally defined as two or more consecutive quarters of negative Gross Domestic Product (GDP) growth. The National Bureau of Economic Research (NBER) describes a recession as, “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” It also regards GDP as the best measure of aggregate economic activity.
Various methodologies have been used to track GDP and the U.S. economy. The first official measure in the 1930s used only current data from IRS tax data, the 1929 economic censuses, Bureau of Labor Statistics data, regulatory and administrative data, and some surveys to supply missing data relating to services.
Richard Froyen, writing in 2005, described the situation in this way: One reads with dismay of Presidents Hoover and then Roosevelt designing policies to combat the Great Depression of the 1930s on the basis of such sketchy data as stock price indices, freight car loadings, and incomplete indices of industrial production. The fact was that comprehensive measures of national income and output did not exist at the time. The Depression, and with it the growing role of government in the economy, emphasized the need for such measures and led to the development of a comprehensive set of national income accounts. (http://www.britannica.com/bps/additionalcontent/18/31881825/Taking-the-Pulse-of-the-Economy-Measuring-GDP)
The NBER has subscribed to a method of determining the troughs and peaks of the economic cycles by compiling business cycle indicator data into composite indices of leading, coincident, and lagging indicators.
Lagging indicators improve or worsen after the economy has started moving from trough to peak or peak to trough. Some examples are Average Prime Interest Rate, Change in Consumer Price Index (CPI) for Services, Average Duration of Unemployment. Coincident indicators measure current economic activity (Non-Farm Payroll, Production, and Personal Income) and are not used for forecasting future economic health.
The duration, depth, and diffusion of leading indicators such as the Weekly Initial Unemployment Claims, Consumer Expectation Index, and the Stock Market Index are thought to predict the course of the economy.
Perception of leading indicators can affect how quickly the cycle changes direction. When consumers stop spending and investors stop investing, the economy will suffer. If consumer confidence improves, other indicators often follow suit, a phenomenon noted in an article from the Boston Globe discussing the 2001 recession:
Consumer psychology is key to the timing of the recovery. Despite the lower interest rates and higher personal incomes, consumer confidence about the current economy as measured by the Conference Board continues to decline. But in a very positive sign, consumers show optimism about economic prospects six months from now. If consumers back this up with an increase in spending, the current recession may follow the recent average pattern and become history by spring. (From Recession to Recovery, Martin and Kathleen Feldstein, December, 2001)
So, did low stock prices cause the current recession or did the current recession cause stock prices to fall? The answer to the ‘chicken-and-egg’ question remains elusive…