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Individuals, not aggregates

Created:
11 July 2008
Written by:
Chris Dillow

It's economists against the world. Whereas most economists (until very recently) have not expected a recession, it seems most non-economists do.

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This reflects discredit on both sides. Economists have always been awful at forecasting recessions, perhaps because they are inherently unpredictable. And much of the gloom from business reflects an unwarranted extrapolation from idiosyncratic misfortune, or is a cover for personal incompetence (funny how profits always fall because of hard trading conditions but rise because of good management, isn't it?), or are part of demands that government do something to help out vested interests.

The truth is, though, that the question of whether we get a recession or not is unimportant. What matters is what recessions do. And here's the key fact. The pain of recession is not distributed evenly, nor as a bell curve, but rather roughly follows a Pareto distribution. In the last recession, one-fifth of firms accounted for 92 per cent of the gross fall in profits and 10 per cent accounted for 83 per cent of the fall.

Recessions, then, impose severe pain upon a minority. And it's impossible to predict well who this minority will be. The fact that housebuilding shares have fallen so far in the last 12 months shows that stock-pickers are as bad as economists at seeing trouble coming.

Which brings us to what we should really worry about. The problem is not that people will lose their jobs in coming months. This happens even in normal economic times.

Instead, the real danger is that the financial system is in no shape to help out that minority of firms that get into distress - as Bradford and Bingley are discovering. At best, this means troubled firms could see savage share price falls, as investors fret that distress will lead to bankruptcy. At worst, these fears will materialize, and a higher proportion of troubled firms will go out of business than usually happens in recession.

Luckily, aggregate data show that company finances are quite healthy, which suggests there are fewer firms near to trouble than there were at the start of the 1990-91 recession.

Unluckily, though, aggregates don't much matter. The story of this recession - if it happens - will be about individuals, not averages.

MORE DILLOW WISDOM...

Read more of Chris's comment peices on his Columnist page, or his macroeconomic analysis on the markets page.

Chris blogs at http://stumblingandmumbling.typepad.com

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