Goldman Finds Most Modern Recessions Were Caused By The Fed

One week ago, Deutsche Bank issued a loud warning that as a result of the aging of the current economic expansion, now the third longest in history at 32 quarters, if with the lowest average growth rate of just 2%...

.... coupled with the collapse in the yield curve...

... and the risk that the Fed could fall behind the inflationary curve as a result of near record low unemployment (assuming the Phillips urve still works which it doesn't)...

... the risk is growing that the Fed could hike rates right into a recession that it itself causes:

... which makes sense: recall BofA's chart from earlier this year which showed that every tightening episode usually ends with a financial "event."


Overnight, it was Goldman' turn to scare its clients with an extended analysis of when and under what conditions the next recession could strike, and as Hatzius and co write in "s economic team write in The Next Recession: Lessons from History, "with the current expansion already the third longest in US history, investors have begun to look ahead to the next recession. We ask how likely the next recession is to come soon and where it is likely to come from....

While some frequent contributors to postwar recessions such as oil shocks look less threatening today, others such as declines in financial asset prices, sentiment-driven investment swings, and too-rapid tightening of monetary policy retain their relevance as recession risks. Combining lessons from this historical investigation, our cross-country recession model, and both our own research and academic research on US-specific leading indicators, we then develop a recession risk dashboard. The dashboard reinforces our view that recession risk remains only moderate.

While the answer to the first part remains elusive, and to Goldman it is still relatively low, the answer for the second part is clear: in the post WW2, virtually every recession (and depression) was caused by the Fed.

Goldman starts with a historical overview of the causes of recessions. Looking at 33 US recessions since the 1850s, it finds that while many pre-WW2 recessions originated in the financial sector, most post-WW2 recessions were caused by monetary policy tightening and oil shocks and, and sentiment-driven swings in borrowing and investment led to recessions in both eras. A similar IMF study of the key contributors to 122 advanced economy recessions shows that even before 2008, financial crises were a fairly common source of modern recessions too.

Here is what Goldman found:

A Historical Look at the Causes of Recessions


A starting point in understanding past recessions is to simply look at the contributions of the various components of GDP during prior downturns. Exhibit 1 shows the cumulative growth contributions over all quarters included in the NBER-defined recessions since the introduction of the national accounts. The main lesson is a familiar one: while consumption has declined more often than not in recessions, investment spending—including inventories, business fixed investment, and housing—has accounted for the largest contributions to declines in output. This same stylized fact holds for a broad international sample of advanced economy recession.


Exhibit 1: Investment Usually Dominates Output Declines During Recessions


We turn next to classifying the most important causes of prior downturns to create a taxonomy of recessions. To expand our sample, we study all prior US recessions as defined by an NBER database that includes 33 business cycles back to 1854, shown in Exhibit 2. Of the 33, 21 occurred before World War 2, when the US economy was much more frequently in recession, and 12 have occurred since.


Exhibit 2: The US Economy Has Spent Much Less Time in Recession Since WW2


Relying on several historical sources, we identify the key contributors to each recession. Exhibit 3 summarizes our findings. We draw four lessons.


  1. First, the most frequent contributors to modern recessions have been monetary policy tightening and oil price shocks, with the former in response to inflation that often gained momentum from the latter.
  2. Second, sentiment-driven swings between over-borrowing and heavy investment followed by deleveraging and investment cutbacks contributed to the two most recent recessions and also played a role in early recessions, especially during boom-and-bust cycles of railroad investment.
  3. Third, while the financial sector has not been the origin of as many modern US recessions, it was a very frequent source of early US recessions.
  4. Fourth, fiscal policy shocks have sparked US recessions, but only in the context of demobilizations from major wars.

Exhibit 3: Major Contributors to Early and Modern US Recessions

With all that in mind, what does Goldman's model say about probability of recession today? According to the bank's preferred tool for answering this question, its cross-country recession model shown in Exhibit 7, while recession risk has risen, primarily due to the decline in spare capacity in the US economy. recession risk remains only moderate at about 13% on a 1-year horizon (compared to an unconditional probability of 23% since 1980) and 24% on a 2-year horizon (compared to an unconditional probability of 34%). 

Exhibit 7: US Recession Risk Has Risen, but Remains Only Moderate

Of course, if Goldman is right, the current expansion, already the third longest, will surpass the 1961-1969 expansion as the second longest in history, and take aim at the 1991-2001, the last real economic cycle the US had before the Fed started inflating bubbles to "deal" with the consequences of previous burst bubbles.

Goldman's conclusion:

Both our cross-country recession model and our US recession risk dashboard suggest that near-term recession risk remains only moderate. But when the next recession does come, where will it come from? Our historical analysis offers three main lessons.  

  • First, the dominant cause of postwar US recessions—monetary policy tightening in response to high inflation often boosted by oil shocks—looks much less threatening in a world with well-anchored inflation expectations and shale-imposed limits on oil prices.
  • Second, this does not mean that over-tightening is not a risk; tightening cycles in the late 1950s were quite tame, but nonetheless ended in recession.
  • Third, the more timeless drivers of the business cycle—the sentiment-driven swings in both financial asset prices and borrowing and investment that are often attributed to “animal spirits”—retain their relevance as recession risks.

So while the Fed clearly has been the driver behind most modern recessions, the irony will be if the US economy is already contracting - as commercial loan data suggest - just as the Fed not only tightens but begins to shrink its balance sheet, a combination that would resut in such a massive expansion in the Fed's reserves (as QE4, 5 and so on are unleashed) some time in 2018, it will make everyone's head spin.