Could We Be in a Recession Right Now?

In the wake of Friday’s dismal jobs report, Kevin Hassett explains the Hamilton model:

The Hamilton model is intuitively quite simple, but in practice it has had a revolutionary impact on the way economists view recessions.
The model works like this: Assume that God sits in a room with two urns (colored red and black) before him. Each urn is filled with little balls that have numbers written on them. In the black urn, the average number on the balls is about 2 1/2, but the numbers vary widely. In the red urn, the average number on the balls is about negative 1/2, though the numbers also vary.
Each quarter, God pulls a number out of one of the urns, and that number becomes U.S. gross domestic product growth for that three-month period. In addition, he tends to take a ball from the urn he drew from in the previous period.
In this setting, the problem for the econometrician is relatively simple. He must identify at any given time whether God is drawing from the red or the black urn. Say we observe a negative GDP number. It might be that the number is from the red urn, and that we have entered a recession. It may also be that the draw was from the black urn, and was just negative because of noise.
Next Report Crucial
How can you tell if the number was drawn from the red “recession urn”? Hamilton’s model tells us that the key is what happens next. If God made a bad draw from the good urn, then the next draw will be back around 2 1/2. If he made a bad draw from the other urn, then the next draw will be negative as well. As the sequence of negative numbers builds up, our feeling that God is drawing from the bad urn grows.
So a crucial thing to watch will be the next report. If it, too, is negative, then we will have had two such employment reports in a row. Since 1960, we have never had two consecutive negative employment months, except for during or shortly after a recession. One could reasonably conclude that God has turned to the red urn. There will be lots of public opinion about a recession between now and then, yet we won’t know until we see the number.

Basically, what he’s saying is that the economy operates on two distributions, one for expansions and another for contracts. Due to the deviations, one might be disguised as the other. We’ll know more with more data. Obviously, getting two lousy reports during an expansion is very rare. In fact, we might be in a recession right now.
For the last five quarters, the economy has grown by 2.54% which is nearly 0.5 standard deviations below the mean.

Posted by on September 10th, 2007 at 2:56 pm


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