An Economics Lesson From 1945

Editor's note: Every Monday for the next few weeks, we'll spend some time digging into the similarities between the U.S. economy from after World War II and today. Be sure to check back each week to keep up with our coverage of the timeline.

'Recession' seems to be everyone's favorite word lately...

People can't stop talking about the downturn our country might be facing.

Inflation is high. We're currently in a bear market. And people are still feeling the lasting effects of the COVID-19 pandemic.

But does that mean we're definitely heading toward a recession?

Before we can answer that question, we must really understand the term "recession"...

According to the National Bureau of Economic Research, a recession is a "significant decline in economic activity spread across the economy for more than a few months."

That's a pretty loose definition.

So many factors play into a recession – like gross domestic product ("GDP"), consumer spending, employment, and household income, just to name a few. All these components could lead to a "significant decline in economic activity."

That adds a level of complexity to actually figuring out if we're in a recession or not. And it's why most people simply look to the traditional sign that a downturn is on the horizon – declining real GDP for two consecutive quarters.

We're currently setting up for that right now...

Real GDP declined 1.6% in the first quarter of 2022. And thanks to our ongoing inflation woes, it's possible that this number will be negative again for the second quarter.

Since it takes so long for the official numbers to come in, it's impossible to know if a recession is happening until it's already too late.

In other words, when we learn the truth, we're already two quarters into a recession. Sounds pretty terrifying, right?

But for many people, it doesn't necessarily feel like a recession...

Without looking at GDP growth in the last two quarters or the market, your day-to-day life might not have changed as much as you'd expect it to in a downturn.

That's because the economy is actually doing quite well...

Employment is strong. Consumer demand is healthy. We haven't seen widespread credit issues.

In short, we're only in a "recession" based on its narrow definition (assuming we're in one at all).

Nominal GDP totaled 6% last quarter. That's a GDP metric based on current market prices. It remains strong... and as we already mentioned, employment is healthy while the Federal Reserve raises interest rates.

We've seen a setup like this before...

History may not repeat itself, but it certainly "rhymes." We could be following a similar playbook to the 1945 recession.

At the time, real U.S. GDP was negative because the government cut spending as World War II ended.

During the war, the U.S. produced beyond its maximum potential GDP. It was "all hands on deck" for a time, but the production was unsustainable.

Said another way, U.S. GDP had nowhere to go but down.

The cut in spending simply brought GDP back down to its maximum potential.

Even as soldiers flooded back into the U.S. and started hunting for jobs, unemployment was just 1.9%. Again, this played out during an official "recession."

In fact, the market kept on rallying throughout the 1945 recession. The market understood why GDP declined... and what was really happening.

These days, 2022 looks a lot like 1945...

Back then, the country was emerging from World War II. Now, we're coming out of the COVID-19 pandemic.

Throughout the pandemic, the government threw the kitchen sink at the economy. Between the Main Street Lending Program, Paycheck Protection Program loans, and multiple waves of stimulus checks, the powers that be did everything they could to keep the economy humming.

But now, it has been about a year since the stimulus ended. The year-over-year comparisons aren't looking as good – much like when the U.S. wound down production and things returned to normal after World War II.

We've already recorded one quarter of negative real GDP growth... and another one seems to be looming.

Despite that, the economy looks strong. Businesses are recovering. Employment figures are encouraging.

Even during the 1945 recession, the market shrugged off the headline print. Instead, investors focused on fundamentals.

It took another year for the market to even blink at what was going on in the economy. And by then, the recession was long over.

Regards,

Joel Litman
July 11, 2022