How we measure recession is wrong. Here’s a better way to do it

Of all the scary words in economics, recession is probably among the worst. Not just because of the bad times we link it with, but because of the way it’s measured.

What if I told you the way we measure recession is wrong? Or at least that we need to give it a rethink?

The widely used rule for a recession is “two consecutive quarters of negative economic growth”. That means two sets of back-to-back periods (of three months each) where gross domestic product – or GDP: the amount of goods and services that we’re producing and selling – shrinks.

Should recession be measured through unemployment rather than GDP?Credit: Matt Davidson

Under that definition, Australia has been in a recession only once since 1991, and that was shortly after the pandemic and its lockdowns hit.

The idea is this: if we’re making and buying less, that must mean we’re having a hard time. And if it happens for six months, that must mean we’re becoming really worse off!

Here’s the thing, though. GDP is already a flawed measure at the best of times. Sure, it can give us an indication of how much we’re pumping out on the assembly line or purchasing at the checkout. But that doesn’t tell us anything about other measures of our wellbeing: environmental damage, our health or education outcomes.

It also doesn’t tell us how growth is shared: an expanding economy doesn’t mean everyone is getting better off. All or most of it could just be flowing to the already well-off.

Right now, as much as a lot of us feel worse off, we’re technically not in a recession. Looking purely at GDP, the Australian economy has managed to tread water.

In the September quarter (and the one before that, and the one before that), GDP grew by a tiny 0.2 per cent – but it was still above zero: close to a recession, but no cigar.

It helps if we split that figure up by population. When we consider the boom in our population over the past couple of years, we have, indeed, gone backwards. For the past year and a half, GDP growth per person has consistently fallen every quarter.

But to better measure and identify recessions, which we tend to see as a signal for economic pain, we should look to the labour market.

Why? Because that’s where most of the impact of a recession is felt: think about job losses and how hard it is to find a job when the economy is tanking, as well as the impact our jobs have on our lives.

Over the past year, our biggest banks have said our strong labour market has helped people muddle through the cost-of-living crisis. We can change our spending habits to keep up with mortgage repayments or work extra hours to keep up with our rent. It’s not fun, but it’s possible.

Lose your job, though, and life is much harder. It can put people under serious financial stress and damage their mental health.

Claudia Sahm developed the Sahm rule.

Enter American economist Dr Claudia Sahm. The tool she developed – called the “Sahm rule” – helps to warn when an economy is entering a recession. It has missed the mark only twice in the past 11 US recessions.

The Sahm formula looks at monthly unemployment data to track how quickly the national unemployment rate has risen compared to the past year. Specifically, it compares the current three-month moving average of the national unemployment rate with the lowest value it has hit in the previous 12 months.

If the current rate is at least 0.5 percentage points higher than the lowest point in the previous year, it means we’re in the early stages of a recession. Measures such as the Sahm rule help us identify weaknesses in our economy and the risk of a recession early. That’s because jobs data is more frequently reported than GDP.

Sahm says changes in the labour market are crucial in understanding the state of the economy.

“If you were put on a desert island and could only have one variable to say what’s going on in the US economy, unemployment is the one you want,” she says. “It really says a lot about whether we’re in good times or bad.”

Sahm’s formula came about in 2019 while she was searching for a better way to fight the next recession. “I had just watched for a decade how hard the Great Recession was on families,” she says. “The goal was to have something people could understand that was very simple, easy to track and really accurate. Your best shot at fighting a recession is to move quickly.”

According to Sahm’s rule, Australia has been in the early stages of a recession for at least one month this year (although the Reserve Bank has argued the Sahm rule should be triggered at 0.75 per cent rather than 0.5 per cent).

When developing the rule, Sahm says she knew from the beginning that examining unemployment would be key. “I already knew, just from my work experience, even small increases in the unemployment rate are a bad sign,” she says.

Australia’s labour market has been remarkably resilient, with the most recent unemployment rate in September coming in at a historically low 4.1 per cent. But we’ve been in – or close to – the danger zone for the past few months.

RBA governor Michele Bullock has managed to walk the tightrope between taming inflation and sparking a recession.Credit: Louie Douvis

Why does this matter? Getting on the front foot is important, especially for policymakers such as the government and central banks, to limit the fallout from an economic slowdown.

Independent economist Saul Eslake has long believed the common definition of a recession is flawed. He points to the two consecutive quarters of negative GDP growth in Australia in 1977: “Nobody thinks that was a recession,” he says.

On the other hand, Australia didn’t see two consecutive quarters of negative GDP growth during either the global financial crisis or the tech wreck in the early 2000s. But Eslake says Australia arguably faced minor recessions during both those periods.

His own metric for a recession, like Sahm’s, focuses on the labour market. He says a recession should be when unemployment rises by more than 1.5 percentage points in 12 months.

Economist Saul Eslake.Credit: Alex Ellinghausen

“The biggest impact of a recession is on those who lose their jobs or take a long time to find them,” he says.

“There’s evidence that people who lose their jobs during a recession, or enter the workforce as school-leavers or university graduates during a recession, take longer than normal to find a job.”

This then has a “scarring” effect. Those who lose their jobs or have difficulty finding one tend to end up earning less over the rest of their working lives.

The better we are at identifying a recession, the better we can be at protecting jobs and longer-term livelihoods.

Of course, it may not be as simple as just monitoring the jobs market. In the US, for example, the National Bureau of Economic Research (NBER) considers a range of measures beyond GDP – including personal income, employment, wholesale and retail sales – when deciding whether to declare a US recession.

And even Sahm says her rule has limitations, especially as we’ve seen big changes in the supply of labour across many countries.

“This particular economic cycle has challenged simplicity in a way that means these simple rules need some kind of extra check,” she says.

But whether we go with a measure that is simpler than the NBER gauge, more complex than the Sahm rule, or timelier than GDP, it’s clear the focus needs to be more on jobs.

If there’s one job our economic leaders have, it’s to keep us, as much as possible, in ours.

Ross Gittins unpacks the economy in an exclusive subscriber-only newsletter. Sign up to receive it every Tuesday evening.