Index of Leading Indicators Signals Recovery - Why the Pessimism?

Clifford F. Thies

Clifford F. Thies is a professor of economics and finance at Shenandoah University in Winchester, Virginia. The following article was written before the attacks on the United States. At the end of this article are comments made by Clifford F. Thies in light of the terrorist attacks.

On July 19, 2001, the Conference Board announced that, for the third month in a row, the index of leading indicators has gone up. In the history of the economic indicator series, whenever the economy was in a recession, three consecutive months of increases in the index of leading indicators has always been followed by an economic recovery. So, why are some conservatives pessimistic?

One reason could be that the pessimistic conservatives fear this could be the first time that the signal of recovery is wrong. The signal of a recovery has been one hundred percent accurate for more than one-and-a-half centuries. There have been no false positives, meaning no signals of recovery not followed by recovery. Nor have there been any false negatives, meaning no recoveries not preceded by the signal. Even with this impressive track record, it would not surprise me if we eventually got a false positive. And, it wouldn't surprise me too much if this signal proved to be the first false positive. But, while there is a theoretical possibility that this will

A second possible reason is that the recovery-when it materializes-will be short-lived, and that we will quickly fall back into recession. Most really bad recessions have been double-dip or even triple-dip recessions. Consider the double-dip recession of January to July 1980 and July 1981 to November 1982. The first punch of the one-two combination knocked President Jimmy Carter out of the White House. The second buckled the knees of (but didn't completely knock out) the Republicans. The "working majority" of the Republicans and their Southern Democrat allies in the House was lost in the mid-term election. And, the Republicans in the Senate though still a majority-were cowed.

The problem with the hypothesis that we will have a double-dip recession is that no honest economist has a clue as to the meandering of the economy beyond the next few months. In the very short run, the index of leading indicators gives us a pretty good idea of where the momentum already in the economy is taking us. In the very long run, presuming that our precious Constitution remains intact, and that we continue to enjoy freedom and democracy, we can be sure that we will be ever more prosperous. It's merely the in-between stage that's hard to pin down.

Will our recovery be weak and short-lived? Will we soon fall back into a recession? I realize I just said nobody knows. But, while there are some real problems in the world, my sense is that they are nothing like the problems we faced back in 1980. Over the past twenty years, we have whipped inflation, pulled out of recession, and won the cold war. Our corporate sector has been completely restructured. Our banks are strongest in the world. Our workers are the most productive in history. Our federal budget is in balance (exclusive of the temporary positive cash flow currently enjoyed by Social Security).

I realize the NASDAQ is nowhere near its peak. I'm not saying that the dot-com boom of a couple years back was irrational. (However, I did diversify my portfolio when the stock market got pricey.) The exuberance of the now past bull market assumed that the positive trends were going to continue indefinitely. Well, it didn't turn out that way. We hit a few snags. But one day, I certainly hope, we'll be home free. We'll round third base and cruise the rest of the way in. In the meantime, we had to return to second base, and get ready for the next crack of the bat.

Does this mean I know from where will come the next surge in the economy? No way! I'm an economist. Not an inventor or an entrepreneur. I don't know where they come up with ideas like the railroad, electrical appliances, cars, radio and television, or personal computers. What I know is that the creative genius unleashed by our free enterprise system will continue to surprise. You see, our economic recovery, when it comes, will not be caused by the statistical regularities in the various economic indicators. It will be caused by the increasing number of creative workers in our economy. Right now, they're in something of a collective funk. But, give them an opportunity to regroup. To recharge their batteries. And, they'll be back at it.

So, to the pessimistic conservatives who fear a double-dip recession, I say, while nobody can forecast the economy's mid-term course, there is no evidence that a double-dip recession is in the cards.

A third possible reason certain conservatives are pessimistic is the lag that is built-into the economy. The index of leading indicators, just as its name implies, leads the economy. This means that the economy won't start to recover until sometime after the signal. Even later, the index of lagging indicators will turn around. It could be several years until we've worked through all the problems associated with the present economic slow-down.

At this point, I should perhaps explain what exactly are the indexes of leading and lagging leaders, and what, for that matter, they lead or lag. The thing that the leading indicators lead, and the lagging indicators lag is the index of coincident indicators. The index of coincident indicators involves (1) employment, (2) production, (3) sales, and (4) income. This makes the index of coincident indicators a comprehensive measure of "the economy." From an apparent peak in December 2000 through June 2001, the index of coincident indicators has fallen by 0.2 percentage points. If this figure holds up after additional information is gathered and any revisions are made, this would mean that we fell into recession in December of last year. Certainly, the economy has slowed down.

The leading indicators includes ten underlying series, including stock prices and the money supply, average weekly hours of employment, manufacturers' new orders, and building permits. These ten series were not selected based on any theory of how the economy works, but merely on the basis that they have done the best job of forecasting the short-term movements of the economy. Having said that, they do seem to involve plans and expectations of the various decision makers in the economy. For example, when contractors are about to begin new construction projects, they first file for building permits. And, when companies start to increase employment, they first increase the hours of workers already employed before hiring new workers.

The lagging indicators includes seven underlying series, including inventories, average length of unemployment, and the ratio of commercial and of consumer debt to income. Just as with the leading indicators, the lagging indicators were chosen simply because they were most consistent in their relationship to the coincident indicators. Even so, it seems that these lagging indicators involve a breakdown of coordination in the economy. An increase in inventories, for example, probably means that companies had plans to sell goods that did not match consumers' plans to buy. Unemployment, for another example, can be viewed as the plans of workers to find jobs that didn't match the plans of employers to hire. Debt, for a third example, balloons when families and companies don't generate the income on which they and their creditors were depending.

Usually, prices coordinate the plans of the various decision makers in a market economy. This is what we refer to when we talk about "supply and demand." But, there are times when coordination breaks down, resulting in distress of unsold goods on the shelf, unemployment, and burdensome debt. And, remember, these problems lag the overall economy. A recession that got underway before President George W. Bush took the oath of office is going to result in distress six to twelve months after he was sworn in. And, the liberal media will do its best to blame the distress on him.

Even if the economy turns around soon, it will be months before the economists get around to collecting the numbers, analyzing them, and then making the announcement. I don't know if you remember, but it was on December 22, 1992, about a month after President George Bush was defeated in that year's election, that the National Bureau of Economic Analysis officially announced that the economy had started to pull out of recession in March 1991. That's right, March 1991. Anybody advising Bill Clinton during that election cycle could tell him that "It's the economy, stupid," because of the lag in the economy. Both the lag in the distress associated with a recession, and the lag in the recognition of a turn-around.

I have to admit there is some sense to conservatives being pessimistic because of the lag in the economy. It would have been more advantageous, politically, if the economy had turned down a year before it did, and started recovering six months later, while Clinton was still President. Democrats would claim that the recovery actually started while they were in office, the way Republicans claim that the recovery for which Clinton continues to claim credit actually started while George H. Bush was president. But, pointing out the complicated facts of economics would do them as much good as it has done us. No matter how much the Democrats tried to explain the workings of the economy, we'd get the credit for the recovery. And, conversely, no matter that in fact-the recession began while the Democrats were in office, we're going to get blamed for the distress that will follow the recession.

But, while some pessimism is understandable, I have to repeat that nobody can forecast the mid-term course of the economy. It is just as likely that the recovery will be vigorous as that it will be weak. With a vigorous recovery, the gloom will soon be gone. In such a case, the political strength Republicans enjoy by reason of their philosophical alignment with the heartland of the country will be reinforced by being the incumbent party during good times. But even if not, the fact that the Republicans could turn the Democrats out of office at the very peak of the economy, means that they'd have at least a halfway decent chance of holding onto office even if the economy is weak.

Additional Comments in Light of the Terrorist Attacks

Here are the rules: war hurts the economy, even though the government figures show otherwise. This is because government counts war production as income, when it is merely a cost of living. Furthermore, war disrupts international business.

Therefore, as far as the economy is concerned, there are some risks involved.

On the other hand, Bush's popularity should strengthen tremendously.

This should allow him to get certain legislation through the Congress, most obviously, developing our own energy resources and strengthening inter-American ties and, on both counts, lessening our dependence on politically unreliable places.

I could say "it depends on how effectively Bush handles the crisis," leaving myself wiggle room.

But I think it is reasonable to expect that we will handle this well enough, so that the consequences for the economy and the politics will be fine.

I have a friend who worked at the World Trade Center. If he is among the dead, he died because he and his co-workers were symbols of the new emerging global economy.